Lecture 1 - principles of taxation

Question 1

tax history up until WW2

Answer 1

1540-1750 - tax became huge issue leading to differences between king and parliament, ending with charles’ execution in 1649.
1750-1945 - income tax introduced in 1799. free trade movement led to repeal of many taxes.

Question 2

tax history after WW2

Answer 2

1965 corp tax and capital gains tax, 1973 VAT, 1984 inheritance tax.

21st century
Leaving the EU has meant the UK can revisit tax rules, and changes like reduction in VAT occurring. Mirrlees review 2010 - prioritised economic efficiency/fiscal neutrality, little change resulted from analysis.

Question 3

what type of government dept is HMRC?

Answer 3

non-ministerial, theoretically removing it from political influence

Question 4

5 reasons for having taxes

Answer 4

necessary due to market failures (public and merit goods)

managing the economy

equity (tax rich, redistribute to poor)

stabilisation of the economy

influencing behaviour

Question 5

why does market failure create need for taxes?

Answer 5

public goods are non-excludable and therefore introduces free rider problems. gov want at least a minimum level of merit goods, so taxes fund them to benefit society as a whole.

Question 6

how do taxes help to manage the economy?

Answer 6

can help with employment levels, the nature/type/location of business activity, the levels of inflation, the balance of payments and relationships with trading partners

Question 7

why does inequity create need for taxes?

Answer 7

some countries may want to tax the rich and redistribute to the poor. the UK has a progressive income tax system. those who earn more pay more, helping develop society in terms of having social welfare/health systems to improve standards of living.

Question 8

how can taxes help stabilise the economy?

Answer 8

as the economy grows, taxes will take money out of the economy to slow it down and avoid inflation. as it slows, nominally less money comes out and it stabilises

Question 9

how can taxes be used to influence behaviour?

Answer 9

e.g.s of soft drinks levies, tobacco taxes. can be positive, and can be used in regulation and protecting things like the environment or groups/the public.

HOWEVER - very little is known about taxpayer behaviour bc society is so complex. tax system is complex so difficult to comprehensively map the impact of changes in taxes and taxpayer responses, and especially to predict in advance.

Question 10

what type of law system is the UK tax system?

Answer 10

common law. tax related laws created by parliament are interpreted as disputes brought before courts to be settled. HMRC guidance is not legally binding, and can be challenged, but does provide useful advice on how to handle taxes.

Question 11

how does the self assessment system for income tax work?

Answer 11

taxpayer is responsible for working out tax liability and reporting it to revenue authority. decreases gov admin costs, pushes them onto taxpayer. for main UK taxes involving self assessment = income, corp, CG, inheritance. HMRC accepts self assessment at face value, then has right to check info and calculations are correct. penalites for not supplying info requested through notice.

Question 12

what are the 4 canons of taxation?

Answer 12

equitable (inc benefit principle), certain, convenient, efficient

Question 13

what does it mean for a tax to be equitable?

Answer 13

must be fair in impact. practical, people are more likely to pay a fair tax.

Question 14

what is horizontal equity?

Answer 14

Those in similar positions are taxed in similar ways. some difficulty in determining those in the same position, e.g. is investment income the same as earned income? very hard to ensure equal amounts of tax are paid by individuals with same taxable capacity.

Question 15

what is vertical equity?

Answer 15

Those in need pay less tax. definitions of ‘those in need’ can be difficult to agree. taxable capacity is unobservable, so usually use ability to pay which is essentially income.

three layers to problem of designing a vertically equal tax system - who pays higher rates? how much higher should it be? then, ensure system achieves these objectives for all taxpayers. Some people are asset rich, income poor. Should wealth holdings therefore be included in ability to pay? Family situation/other less quantitative measures can be argued for but how can we include them?

Question 16

what is the benefit principle?

Answer 16

Also from Adam Smith - Where tax is charged based on benefit received, e.g. council tax where city dwellers pay more than rural residents, large families pay more than childless. using NHS as example, those who use it more tend to have lower incomes, so actually can they pay higher taxes? relatively few activities can effectively be taxed using benefit principle, impossible to choose with public goods and hard to decide time frames for measurement.

Question 17

what does it mean for a tax to be certain?

Answer 17

there is clarity about how much is owed and when. should be simple to compute, should also be certain in impact, or hard to avoid. corp tax can be considered poor in this respect as it’s unclear whether shareholders, employees, customers or others bear the ultimate burden. rule changes to taxes rarely made retrospectively due to need for certainty.

salience = awareness of tax burden. income tax more salient than VAT.

Question 18

what does it mean for a tax to be convenient?

Answer 18

easy to pay. usually better to have deducted at source - good for gov as it means revenue received earlier than direct assessment. however tax at source normally calculated independently of taxpayers circumstances and may not be correct.

Question 19

what are the characteristics of an economically efficient tax?

Answer 19

AKA fiscal neutrality.

tax shouldn’t distort economic decision making in terms of: spending vs saving, what to spend money on, whether to earn money or stay at home. in reality this is difficult to achieve, and sometimes has unanticipated consequences. govs also want to influence decision making in some cases.

Question 20

what is a corrective or pigouvian tax?

Answer 20

taxes designed to correct externalities or internalities in the market, like environmental or alcohol taxes.

Question 21

what is an administratively effective tax?

Answer 21

the tax should cost as little as possible to administer. cost vs benefit. taxes have explicit costs, like tax advisers, and implicit costs such as time spent. total compliance costs for the tax system are huge, and are disproportionately borne by small businesses. the more a tax costs to administer, the less is left for expenditure.

Question 22

what are the two recent additions to the four canons of tax?

Answer 22

simplicity - linked to certainty and convenience, too much complexity allows opportunities for tax avoidance. policy makers must be able to identify causes of complexity to remove them, not always possible.

flexibility - changes or can be changed easily in response to changes in the economic environment. can have a stabilising effect on the economy. designing for simplicity helps taxpayers calculate liabilities.

Question 23

what is a direct vs indirect tax?

Answer 23

direct - tailored to circumstances of individual

indirect - suffered by all equally whatever circumstances, unless transactions are avoided.

Question 24

what is a tax base?

Answer 24

what you earn, spend, or own. tax base is what the tax rate is applied to. there are three types: income, wealth/capital, consumption.

Question 25

how does using income as a tax base work?

Answer 25

for individuals, income tax. for companies, corporation tax. for companies, profit can be measured in various ways, so problem of definition

Question 26

what is the laffer curve?

Answer 26

proposes tax revenue 0% if rate is 0 or 100%. Tax revenues rise when rate is low, encouraging growth of economic activities to compensate for increase. After optimal tax rate where gov obtains max possible revenue (hard to tell where this is), there is a diminishing incentive to work harder or invest, and more incentive to avoid taxes. At 100% no one bothers to work or invest. Optimal point depends on: types of tax in system, economy growth, ability to avoid tax.

Question 27

how does a tax base of wealth/capital operate?

Answer 27

taxed on taxpayer’s accumulated wealth, its transfer or changing values. in this category = CG, inheritance, stamp duty, council tax. The few wealth taxes in UK are currently imposed on realisations basis, i.e. applied when taxpayer disposes of wealth and not through period of ownership. Useful for redistributing wealth but difficult to actually value wealth. Wealth taxes have proven relatively cheap to collect, but general wealth tax as primary base likely to be expensive once individually assessed. Also unlikely to raise enough revenue alone for most countries.

Question 28

how does consumption as a tax base work?

Answer 28

taxes on spending, e.g. VAT and excise duties. Taxes what an individual takes out of the economy. Doesn’t tax return on investment until spent, so significant incentive to save. Have become popular recently, but only a few countries use it as primary base.

Question 29

what kind of rates can a tax have?

Answer 29

average, marginal, progressive, regressive, proportional

Question 30

what are the formulae for average and marginal tax rates?

Answer 30

average rate = total tax paid/tax base

marginal rate = tax paid on next £1 of income or earning

Question 31

what is a progressive vs regressive vs proportional tax rate?

Answer 31

progressive - those who have greater ability to pay pay more tax. income tax in UK is progressive, corporation tax now also progressive. marginal tax rate > average tax rate. Rate of tax to be paid increases faster than increase in tax base. Wealthy taxpayers bear a higher burden of tax overall, not just higher rate.

regressive - e.g VAT. marginal tax rate < average tax rate. Rate of tax to be paid increases more slowly than increase in the tax base. Poorer taxpayers pay a heavier burden of tax than the wealthy.

proportional - just a flat % rate, same percentage for everyone. marginal tax rate = average tax rate. Rate of tax to be paid increases directly in line with the tax base.

Question 32

what is the tax burden?

Answer 32

the degree to which a tax/specific collection of taxes/tax system viewed in entirety reduces taxpayer’s economic wellbeing. It is a question of who in society bears the impact or incidence of tax. Govs can choose to spread burden equally, or may decide wealthy should be asked to bear higher burden than poor. Secondary impacts can occur when taxed charged, like changes in purchasing patterns. Two economic concepts for understandings what may happen as result of tax change:

substitution distortion - when individuals consume more of one item rather than another because of tax effects. also called excess burden of taxation. spending power transferred from taxpayer to state.

income distortion - transfer of wealth from taxpayer to gov caused by tax. describes reduction in amount taxpayer can consume out of the money they earn, due to taxes. often encourages individuals to put in more effort, work harder, seek better investments to cover loss. however, if they believe tax is excessive they may give up entirely (retire) or switch to lower tax activities

If tax system not fiscally neutral there is chance that economic cost of tax to consumers and producers > revenue raised by tax. Results in excess burden of taxation.

Question 33

what are the two elements of the incidence of tax?

Answer 33

Formal incidence - falls on those who must actually pay the tax. Often easier to identify.
Effective incidence - falls on everyone whose wealth or income is reduced or purchase opportunities changed in any way by the tax. Should be considered to plan for effects of tax changes.

Question 34

what is the tax wedge?

Answer 34

Difference between what purchasers pay for good or service and what suppliers get of this payment. As demand/supply levels changed due to price, tax wedge created by interaction of new demand and supply levels caused by tax inc/exc price.

for indirect taxes like VAT, tax wedge is difference between marginal cost of producing and selling a good and marginal benefit from consumption. in UK, tax wedge = VAT. item sold for £100 before VAT has marginal benefit from consumption of £120, because this is what purchaser is prepared to pay for it.

for direct tax, tax wedge = difference between marginal value of leisure sacrificed by worker and marginal value to society of another hour of work. in cases of taxes on unearned income, tax wedge = difference between gross and net after-tax rates of return.

Question 35

what are earmarked or hypothecated taxes?

Answer 35

taxes raised to pay for specific activities. Usually unpopular with treasury as constrains how they use tax revenues. E.g. congestion charge in london, money supposedly spent directly on improvements to infrastructure and public transport in london.

Question 36

what are tax reliefs and how can they be delivered?

Answer 36

tax reliefs can relate to what is taxed, rate of tax, who pays the tax and the timing and administration. can be delivered through:

exemption - amount excluded from tax base
deduction - amount deducted when calculating tax base
credit - direct reduction in calculated tax liability
rate relief - normal rate is reduced
deferral - liability is delayed to be paid later.

tax reliefs can be better than grants as it removes need for application/approval process and gov not politically accountable for tax expenditures. tax reliefs mean gov loses control over which taxpayers are benefitting from them. some evidence tax expenditures are used for tax avoidance.

Question 37

what is tax avoidance?

Answer 37

avoidance = legal manipulation to reduce tax. some literature has ‘acceptable vs unacceptable’, both are legal, both are avoidance.
penalties charged as an additional percentage of tax involved, and are linked to taxpayer behaviour. levels of culpability:

careless - failed to take reasonable care, max penalty 30%

deliberate but not concealed - inaccuracy is deliberate but taxpayer has not tried to conceal it from HMRC, max penalty 70%

deliberate and concealed - taxpayer made deliberate mistake and made arrangements to hide it from HMRC, max penalty 100%.

Question 37

what is tax evasion?

Answer 37

evasion = illegal manipulation of affairs to reduce tax.
not declaring income, not registering for VAT, paying VAT, smuggling alcohol and tobacco products, driving round with ‘red’ fuel.

Question 37

what is tax planning and how is it different to tax avoidance?

Answer 37

tax planning = taking advantage of tax rules to minimise tax burden.
avoidance vs planning - both cases trying to pay less. difference in how you make use of tax act. tax avoidance means tax loopholes, taking advantage of legislation by using in ways that were not intended. tax planning is saving tax in the way that it way intended to be done. e.g. putting things in pension pots means lower tax, that’s tax planning because it’s exactly what the legislation was put in place to encourage. e.g. foreign businesses only pay UK if they have a permanent establishment. having HQ in Ireland and benefiting from lower taxes would be tax avoidance.

Question 37

what is the tax gap?

Answer 37

The tax gap = difference between tax actually collected and that should be collected. All tax gap estimates are subject to error. HMRC uses risk based compliance strategy which focuses on areas of highest risk.