Taxation

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    A direct tax is a tax levied directly on a consumer (income tax) or firm (corporation tax). An indirect tax is a tax levied on a good or service (VAT).

    Progressive, regressive and proportional taxes: – A progressive tax is one in which the proportion of income paid in tax rises as income rises. – A regressive tax is one in which the proportion of income paid in tax falls as income rises. – A proportional tax is one in which the proportion of income paid in tax stays the same as income rises.

    A good tax system is one that: – Raises enough revenue to fund government spending. – Does not distort the economy by creating inefficiencies (i.e. no government failure). – Is transparent, that is, taxpayers know who has to pay what tax, how much tax must be paid and when the tax must be paid. – Allows the taxpayer to pay the tax adequately or fairly. – Is compatible with foreign tax systems.

    Reasons for taxation:

    1) Government Spending.

    A government must raise tax revenue to fund government spending. The government could borrow funds from banks and other governments but borrowing is unsustainable in the long-run and must be repaid by taxes.

    2) Market failure.

    A government must tax to correct market failure. For example an indirect tax must be placed on goods that create a negative externality so that the externality is internalized and the Pareto efficient allocation of resources is achieved.

    3) Business Cycle.

    A government must increase government spending and decrease taxation in a recession.

    4) Redistribute Income.

    A government may need to tax the rich to redistribute income to the poor if poverty and inequality is high.
    Laffer Curve The Laffer curve posits that tax revenue will first rise and then eventually fall as tax rates increase. This result is due to the effect that income tax has on the incentive to work.

    Laffer Curve

    As income tax initially rises, tax revenue increases. At T* the government have set the income tax rates that maximize tax revenue. After T*, any further increase in income tax means a lot of workers will quit their jobs because their after-tax wage is too low, they would rather go on benefits. Workers may also have an incentive to evade tax if it is too high. So tax revenue begins to fall. At a 100% rate of tax, nobody works so tax revenue is zero.

    The Laffer curve suggests that governments may need to decrease tax rates to increase tax revenue.

    A Rise in Direct Tax Rates A rise in direct tax rates (let’s say income tax rates) may have the following effects:

    1) More Equal Income Distribution.

    An increase in income tax rates should make income tax more progressive, so the richer you get the more income tax you pay in percentage terms. Income distribution becomes more equal because the rich pay even more income tax than the poor in terms of the percentage of their income, so the Gini coefficient will fall. Also, the government could use the increased tax revenue from taxing the rich more to subsidise poor families to decrease inequality and the Gini coefficient even further. However, the rich may be incentivized to pay for accountants to find loopholes and dodge paying the higher tax rates. Furthermore, the rich may divert their savings towards foreign tax havens to avoid paying increased taxes in the UK. More tax avoidance (legal) and tax evasion (illegal) will occur. Additionally, increased taxes may decrease AD and lead to job losses for the lowest paid workers. So income distribution may not become that much more equal.

    2) Higher Unemployment.

    An increase in income tax rates means people get less disposable income from working because their after-tax wage is lower, this disincentivizes people from working. Unemployment will rise because the unemployed have even less incentive to enter the work force and some workers quit their jobs if unemployment benefits give them more than wages. Moreover, the higher tax rates will discourage workers from working over-time or seeking promotion because their net pay is lower than before the tax hike. But, the government may also increase the tax-free allowance at the same time, this will encourage the low income workers to remain employed and may encourage the unemployed to enter the work force. Also, workers seeking promotion may continue to do so anyway because their disposable income still rises even if tax rates rise.

    3) Lower Economic Growth.

    An increase in income tax rates may decrease economic growth. An increase in income tax means disposable income falls, consumers have less money to spend so consumption falls, AD falls and real GDP falls. Additionally, if an increase in income tax disincentivizes people from working then labour hours fall, the PPF shifts left and real GDP falls. Furthermore, firms may be discouraged from investing because consumers have less disposable income, so investment falls, AD falls and real GDP falls further. Multiplier effects mean AD and real GDP will fall even further. There is an increase in leakages and a fall in injections and the economy may fall into a recession. The extent of the fall in real GDP depends on the magnitude of the rise in income tax rates. A large rise in income tax rates will decrease disposable income, consumption, AD and real GDP significantly. Also, the more elastic are AD and LRAS, the larger the fall in real GDP.

    4) More Tax Revenue.

    An increase in income tax rates should increase the government’s tax revenue. As income tax rises, workers pay a higher proportion of their income in tax so the government receives more tax revenue. This gives the government more funds to increase spending on health and education to increase the economy’s efficiency and shift LRAS right. Although, the Laffer curve suggests that an increase in income tax rates may decrease the government’s tax revenue. After T* on the above diagram, any further increase in income tax means a lot of workers will quit their jobs because their after-tax wage is too low, they would rather go on benefits.

    A Rise in Indirect Tax Rates An increase in indirect tax rates (let’s say VAT) may have the following effects:

    1) Lower Economic Growth.

    An increase in VAT discourages consumers from buying goods so consumption falls. Also, a rise in VAT means firms’ costs rise and their profits fall, so firms are discouraged from investing and investment falls. AD falls, the multiplier effect makes AD fall further, and real GDP decreases. There are more leakages from the circular flow of income so the economy contracts. Moreover, because firms’ costs rise, LRAS shifts left and real GDP decreases further. But, the extent of the shifts in AD and LRAS depends on the degree of the rise in VAT. A small rise in VAT will have only a small effect on AD, LRAS and real GDP. Furthermore, other factors like export-led growth may cause AD and real GDP to increase even if VAT rises. Additionally, the government may have to increase VAT if the economy grows too fast.

    2) Tax Revenue.

    An increase in VAT may increase tax revenue for the government. Consumers will be paying more in VAT every time they buy a good so more tax revenue should be collected. The government will then have more revenue to spend on health, education and the infrastructure to develop the economy. However, a rise in VAT will only increase tax revenue if demand for goods and services is price inelastic. An increase in VAT when demand is elastic means consumers pay more VAT for each good but quantity demanded falls so far that the total amount of revenue collected from VAT falls.

    3) Inflation.

    An increase in VAT means firms’ costs rise so they must increase their prices and consequently inflation increases. Additionally, if prices rise then real wages fall, workers and trade unions will demand increased money wages to bring real wages back up to their level before prices rose. Increased money wages means firms’ costs rise so firms increase prices further, workers again demand increased money wages and the wage-price spiral escalates. At the extreme this could cause hyperinflation. But, the possibility of a wage-price spiral depends on the strength of trade unions, if trade unions are weak then money wages may not rise much. Also, if workers suffer from money illusion then they do not consider their real wage and thus do not demand increased money wages.

    4) Inequality.

    An increase in VAT may increase inequality because VAT is effectively regressive, that is, the poor pay a higher proportion of their income in VAT than the rich do. This is because poor people are more likely to spend most of their income and save only a small amount compared to rich people who are likely to save a larger proportion of their income. However, the extent of the rise in inequality depends on what goods are hit by the increase in VAT. If alcohol, gambling, petrol and tobacco do not suffer a rise in VAT then the poor may not be affected much. Maybe the rise in VAT is on goods that are bought mainly by rich people, making the rise in VAT progressive.

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