4.5.2 taxation

3 TYPES OF TAX

• progressive

• proportional

• regressive

PROGRESSIVE TAX

• where those who are on higher incomes pay a higher marginal rate of tax (pay higher % of income on tax)

• direct taxes tend to be progressive(e.g. income tax)

PROPORTIONAL TAX

• where proportion of income paid on tax remains the same whilst income of taxpayer changes e.g. 10% of income is spent on tax, regardless of income

• Everyone pays same % of income on tax

REGRESSIVE TAX

• where proportion of income paid in tax falls as income of taxpayer rises

• those on higher incomes pay a smaller % of their income on tax

• most indirect taxes are regressive

• e.g. same rate of VAT- those on higher wages this represents a small proportion of their earnings compared to those on low wages

VARIABLES THAT CHANGES IN DIRECT AND INDIRECT TAXES AFFECT

• incentives to work

• tax revenues- the Laffer curve

• income distribution

• real output and employment

• price level

• trade balance

• FDI flows

INCENTIVES TO WORK- NEGATIVE IMPACTS OF HIGH TAXES

• high marginal rates of tax will discourage individuals from working (free market economists argue that supply of labour is elastic so decrease in marginal taxes on income will lead to a significant increase in work as individuals work longer hours and more people join the workforce)

• high taxes on high income earners could encourage them to move abroad

• taxes on poor may lead to poverty trap

• high income tax reduces incentives more than high VAT- so switch from direct to indirect taxes may increase incentives

INCENTIVES TO WORK- EVALUATION OF NEG IMPACT

• no definite evidence for link between income tax and incentives (e.g. nordic countries have high taxes but have similar rates of growth compared to lower tax countries like UK)

• higher taxes mean people have to work longer hours in order to maintain their income and so even increases the incentive work

TAX REVENUES

• laffer curve shows how much tax revenue gov receives at each level of tax

• up until ‘T’, as tax rates increase, gov tax revenue increases

• after ‘T’, disincentive to work (may lead to tax evasion/avoidance) leads to falling tax revenue

• ‘T’ is the optimum tax rate where the gov can maximise their revenue

• revenue from indirect taxes are uncertain as they depend on consumer spending

INCOME DISTRIBUTION

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

• regressive tax 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

• high corp taxes take money from shareholders and give to gov to spend on public and merit goods

REAL OUTPUT AND EMPLOYMENT

• rise in direct taxes will reduce disposable income an individual has → cause a fall in their spending → fall in consumption and investment (less profits for firms) → fall in AD

• higher indirect taxes increase costs for firms → decrease SRAS → impact will depend on where the economy is producing

• 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 (increase unemployment)

PRICE LEVEL

• taxes can impact LRAS, SRAS and AD

• so these changes will impact price depending on where economy is producing

• indirect taxes often cause cost push inflation

TRADE BALANCE- POS IMPACT OF INCREASE IN TAXES

• rise in taxes → decrease income → decrease consumption → spend less on imports

• imports in UK are highly income elastic

• so trade balance will improve in SR

TRADE BALANCE- EVAL OF POS IMPACTS

• LR- lower AD → reduce businesses’ need to invest → reduce competitiveness → exports decrease

FDI FLOWS- POS IMPACT OF LOW TAXES

• low taxes on profit in a country → encourage investment in that country since it will help them to see a higher level of return → increase FDI into that country

FDI FLOWS- EVAL OF POS IMPACT

• problem with this is that it can be a ‘race to the bottom’- countries have to continue to lower their taxes to encourage investment

• eventual result is a fall in revenues