4.5.2 - Taxation Flashcards
Define progressive tax
A progressive tax is where the average rate of tax (as a %) rises as income increases.
Define regressive tax
A regressive tax is a tax which takes a higher percentage of tax revenue from those on low incomes
Define proportional tax
When the marginal rate of tax is constant leading to a constant average rate of tax.
Define laffer curve
A (supposed) relationship between economic activity and the rate of taxation which suggests there is an optimum tax rate which maximises
total tax revenue.
Define indirect tax
An indirect tax is imposed on producers (suppliers) by the government. Examples include excise duties on cigarettes, alcohol and fuel and also value added tax.
Define direct tax
A tax on income and wealth e.g. income tax or corporation tax where the burden of the tax cannot be passed on to someone else.
Define income
Income Income represents a flow of earnings from using factors of production to generate an output of goods and services. For example, wages and salaries are a factor reward to labour and interest is the flow of income for the ownership of capital.
State what variablesd are affected by changes in direct and indirect taxes
o incentives to work
o tax revenues: the Laffer curve
o income distribution
o real output and employment
o the price level
o the trade balance
o FDI flows
How does taxation affect incentives to work
●A rise in marginal rates of income tax for people on high incomes can reduce the incentive for people to work, as they will receive a smaller share of the additional income they earn. This can lead to reduced labour supply, as some people choose to work less or not at all. This is because the opportunity cost of not working has reduced.
- BUT Free market economists argue that the supply of labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as individuals work longer hours, accept promotions and more people join the workforce
How else does taxtion affect work incentives
● High taxes on high income earners could encourage them to move abroad and
taxes on the poor may lead to a poverty trap.
● It is income tax which is important: high income tax reduces incentives more than
high VAT. Thus, a switch from direct to indirect taxes may increase incentives.
Evaluate the idea that increased taxes decreases work incentives
- Nordic countries have high taxes and welfare benefits but have similar rates of
growth compared to lower tax and government spending countries like US and UK.
● It can be argued that higher taxes mean people have to work longer hours in order
to maintain their income and so even increases the incentive work.
What does the laffer curve indicate
●a rise in the tax rate does not necessarily increase tax revenue. If people were taxed at 100%, they would not do any work and this
means that tax revenue is 0 at both 0% and 100%.
● Tax revenue will initially rise as the tax rate is increased but it will come to a point (the efficient tax rate is what its called officially)
where tax revenue is maximised and will then fall. As tax rates rise, motivation and drive
will fall so there will be a fall in output and there is an increased incentive to use tax
avoidance and tax evasion. T is the optimal tax level, which maximises revenue.
- Revenue from indirect taxes can be uncertain as they depend on consumer
spending patterns.
LOOK up laffer curve
Effect of taxation on income distribution
● A progressive tax system will increase the equality of income distribution as more
money is proportionally taken from the rich than from the poor. A regressive one will
decrease income equality. Since direct taxes tend to be progressive and indirect
taxes regressive, a move from indirect to direct taxes will improve equality.
● Inheritance taxes are the most progressive form of taxation. High corporation taxes
take money from shareholders, who tend to be very well off, and give them to the
government to spend on the poor.
● EVAL : PROGRESSIVE TAX EFFECTIVENESS DEPENDS ON IF IT IS ALONE OR WITH BENEFITSOne problem with using tax to redistribute income is that it does not give the poor anything, so the system needs to be supported with benefits.
How does taxation affect price level
- increase income tax reduces disposabole income, thus dampening demand as consumers are unable to afford as much so demand pull inflation is reduced. Corporattion tax reduces amount of profit leftover for investment by firms so AD and demand pull inflation reduces albeit investment isnt as big a component of AD as consumption (only 15%)
- indrect taxes like VAT cause cost push inflation, depending on the PED of the good being produced (if inelastic, likely to cause inflation as incidence of tax falls entirely on the consumer)
Why is demadn likely to fall by a largr amount as tax rates reach a certain level
As with direct taxes, there is likely to be an optimal tax rate for indirect taxes such as VAT.
As tax rates rise, goods and services become less affordable thereby reducing demand. At
low tax rates, demand is likely to fall by a lower proportion than the rise in price.
HOWEVER!!!!!
a) goods will become less and less affordable as tax rates rise
b) more consumers will seek alternatives on the black market or otherwise. For example,
higher tax rates on diesel would push more people to use other types of car or public
transport. They could also seek out cheaper diesel smuggled from abroad.
How does taxation affect real output and employment
- A rise in direct taxes will reduce the
level of disposable income an individual has, which will cause a fall in their spending
and thus a fall in AD. It could also cause a fall in leftover profits for businesses and
therefore a fall in investment.
EVAL: effect this has on output will depend on where the economy is: whether it is at full employment or not. - ● On top of this, higher indirect taxes and NICs increase costs for firms and this will
decrease SRAS. This impact will again depend on where the economy is producing.
● It can be argued that income taxes cause a disincentive to work and therefore
reduce LRAS as the most skilled workers go overseas and more people become
inactive.
Effect of taxation on trade balance
- A rise in taxes will decrease income (or sales tax increases prices for domestic consumers leaving export prcies unaffected, tariffs are an indrect tax making imports pricier) and therefore decrease consumption,
theoretically this will also mean consumers spend less on imports . EVAL; depends on wehter imports are income elastic or not - Imports in the UK have been found to be highly income elastic. As a result, the trade balance will improve in the short run. becuase fall in incomes will cause a proportionately larger fall in demand for imports
- However, in the long run, lower AD will reduce businesses’ need to invest and this
could reduce competitiveness meaning that exports decrease.
How does taxation affect FDI flows
● Low taxes on profit and investment tend to encourage businesses to invest in a
country since it will help them to see a higher level of return.
● The problem with this is that it can be a ‘race to the bottom’ where countries have to
continue to lower their taxes in order to make them the lowest to encourage
investment; the eventual result is a fall in revenues for all countries.; CONFLICTS WITH MACROECONOMIC OBJECTIVES OF INCOME EQUALITY
Differences between horizontal equity and vertical equity
Horizontal equity: people who have similar incoems and ability to pay taxes should pay the same amount of tax;
vertical equity: people who have higher incomes should be paying more tax than those on lower incomes - progressive tax system achieves this
What is aim of regressive tax
- encourage supply side growth
- by reducing taxes of the rich the gov will hope that the economy will benefit from trickle down effect
- this tax gives people more of an incentive to worker harder and earn more income
Pros of wealth tax
- big revenue earner for gov; growth in wealth over last decade due to globalisation
- reduce wealth/income inequality; directed to education and healthcare
- can target windfalls (unexpected rise in prices of assets for whatever reason)
- can promote efficient re-allocation of wealth; if there is a wealth tax in place people will acrtively seek a high yielding, productive asset to invest in so resource allcoation is more efficient as low yield asset investment is minimised
cons of wealth tax
- discourages investment, income generating activity and growth
- risk of emigration; ;affer curve
- tax loopholes; tax avoidance
- admin challenges; taxing the right assets and value
evaluate wealth tax
- rate; higher the rate, the more cons than pros as more trade offs
- assets chosen targets low yield, less productive asset as well as windfall over more productive increases in assets prices although this is super hard
- enforcement; sufficient punishment
What is the reason behind the laffer curve
- disincentives to work harder/be entrepreneurial; people begin to substitute work for leisure bc working that bit extra is pointless since they amount left after paying extra tax isn’t much more
- emigration; higher skilled workers leave, these are the biggest tax payers. most productive workers so massive con
- tax evasion (llegal) /tax avoidance (legal) unintended consequence
