4.5.2 Taxation

Question 1

What is tax used for?

Answer 1

To pay for the number of goods and services that the government provides

On top of this tax can be used to correct market failure at a microeconomic level and to manage the economy and redistribute income at a macroeconomic one

Question 2

What is the UK government’s current aims?

Answer 2

To include keeping the burden of tax low, improving incentives, using equitable taxes, correcting market failure and taxing spending rather than income

Question 3

What is progressive tax?

Answer 3

Where those who are on higher incomes pay a higher marginal rate of tax; they pay a higher percentage of their income on tax

Direct taxes tend to be progressive, for example income tax

Question 4

What is regressive tax?

Answer 4

Where the proportion of income paid in tax falls as the income of the taxpayer rises

Those on higher incomes pay a smaller percentage of their income on the tax

Most indirect taxes are regressive, for example everyone pays the same rate of VAT and for those on higher wages this represents a smaller percentage proportion of their earnings compared to those on low wages

Question 5

What is proportional tax?

Answer 5

Where the proportion of income paid on tax remains the same while the income of the taxpayer changes

E.g. 10% of income is spent on tax, regardless of income

Everyone pays the same percentage of their income on the tax

Question 6

How do tax changes impact incentives to work?

Answer 6

• high marginal rates of tax will discourage individuals from working
• 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
• 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
• however there is no hard evidence for the link between income tax and incentives
• Nordic countries have high taxes and welfare benefits but have similar rates of growth compared to lower taxes 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 to work

Question 7

How do changes in taxes impact tax revenues?

Answer 7

• the laffer curve shows that a rise in tax rate doesn’t necessarily increase tax revenue
• if people were taxed at 100%, they would not do any work and this means that tax revenue is at 0 at both 0% and 100%
• tax revenue will initially rise as tax rate increases but it will come to a point where revenue is maximised and will then fall
• as tax rate increases, motivation and drive will fall so there will be a fall in output and there is an increased incentives to use tax avoidance and evasion
• 50% is the optimal tax level
• revenue from indirect taxes can be uncertain as they depend on consumer spending patterns

Question 8

How do tax changes impact income distribution?

Answer 8

• a progressive tax system will increase the equality of income distribution as more money is proportionally taken from the rich than from the poor