An introduction to taxation

Week 5

What are the roles of the government?

• Direct provision of goods and services (often both certain private goods and public goods).

• Regulating private activities (e.g., price floor, pollution control, administration of justice).

• Redistribution of income (e.g., income support programmes for the poor).

• Stabilisation of the economy (fiscal and monetary).

What is taxation a form of?

Fiscal policy

What is fiscal policy?

Governmental purchases and sales, taxes, and transfer payments, through expenditures and taxation.

What does tax revenue finance?

The expenditure of other fiscal policy instruments, as well as financing other governmental activities.

What are the primary source of revenue for the government?

Taxes

What are taxes?

Compulsory payment imposed by the government.

What are taxes not?

NOT just a fee to use governmental services.

What is tax base?

The item or economic activity on which the tax is levied.

What are the three types of tax base? and what are they?

• Income - earnings made through a particular time period (national insurance contributions for state pension).

• Wealth - the value of what has been accumulated (e.g, council tax)

• Consumption and/or production (e.g, cigarette tax; VAX)

How do taxes affect our economy?

• Taxes reallocate productive resources from the private sector to the public sector.

• Consumers’ purchasing power to demand resources in the private sector is reduced.

• Taxes on specific goods and services discourage production and consumption of those goods.

• Government can use tax revenue to demand resources in the public sector, to be used to fulfil the aforementioned roles.

What is an economy?

An economic system in which economic activities by the government are significantly large.

What is a mixed economy?

An economy organized with some free-market elements and some socialistic elements.

What is a pure market economy?

Dependent on the forces of demand and supply. As such, the role of the government is limited to ensuring market stability, promoting fair competition, creating necessary regulatory frameworks, and ensuring safety.

Why is it important to know the size of your government?

• To measure the size of the government expenditure, as a % of the size of the economy as a whole.

• To address market failure.

• To provide, implement and enforce laws and regulations

• To address equity and fairness

What is the Benefit Principle? and examples.

A direct link between the payers and the recipients of the benefit, (e.g., user fees, charge, prices, etc).

What are the advantages and disadvantages of the Benefit Principle?

Advantages:

• Direct link between MSC and MSB of resource use

• Towards efficient resource allocation.

Disadvantages:

• Lack of income redistribution

• (In the case of public goods) how can we correctly measure peoples marginal valuation of government-provided goods?

What is the Ability-To-Pay Principle? and examples.

The ability of the tax payer capacity to pay the taxes. (e.g., income taxes)

What are the advantages and disadvantages of the Ability-To-Pay Principle?

Advantages;

• More equitable distribution of taxes (or the burden of taxes)

• Horizontal equity: Those who have the same ability to pay should pay the same amount of tax.

• Vertical equity: People with different abilities to pay should pay different amounts of tax.

Disadvantages:

• How do we define ‘ability to pay’?

• Is income the only measure of ‘ability to pay’?

• How about wealth?

• How do we choose a ‘collectively agreeable’ notion of equity?

• Equity is subjective

What kind of criteria are commonly applied, in evaluating government finance (taxation practice)?

• Efficiency

• Equity

• Simplicity / Administrative ease

What is efficiency in evaluating government finance?

Economists strive for efficient resource allocation in taxation; one goal is to raise tax revenue with minimum distortion in the private sector.

What is equity in evaluating government finance?

Efficiency in resource allocation does NOT imply (always result in) equitable (fair) resource allocation.

What is administrative ease in evaluating government finance?

The easier to administer a tax system, the lower the administration cost, and less costly for the citizens to fulfil the duty, and provide less motivation to evade taxes.

What is tax evasion?

Noncompliance with the tax laws (i.e., not paying the tax one is supposed to pay).

Is tax evasion illegal?

Yes

What is tax avoidance?

Changing your behaviour, without breaking the laws (i.e legally), to reduce the amount of tax you owe.

What can the criteria commonly applied, in evaluating government finance (taxation

practice) reduce?

Can contribute to reducing both tax evasion and tax avoidance.

What is the equation for Average tax rate (ATR)?

ATR = £ tax paid / £ tax base

What is the equation for Marginal tax rate (MTR)?

MTR = £ additional tax paid / additional pound of the tax base

What is the Marginal tax rate?

Is the tax rate for the last pound of the tax base.

What is a tax bracket?

A range of tax base level to which a particular MTR is assigned.

What is proportional / flat-rate tax?

A tax whose tax rate structure is such that the ATR is constant.

E.g. Suppose that for every additional pound you earn, you must pay the income tax of 10p.

What is the MTR on your first pound earned?

10%

What is the MTR on your tenth pound?

10%

Does the MTR every change?

No

What is the ATR percentage?

10%

What is progressive tax?

A tax whose ATR increases as the tax base increases.

E.g, UK income tax

For the ATR to increase as the tax base increases, what should be happening to the MTR?

The MTR must be increasing.

What is regressive tax?

A tax whose ATR decreases as the tax base increases. (i.e, MTR decreasing).

E.g., UK National Insurance Contribution