Taxation (Cambridge (CIE) A Level Economics): Revision Note

Types of taxes

• The main source of government revenue is taxation

• Direct taxes are taxes imposed on income and profits

  • They are paid directly to the government by the individual or firm 

    • E.g., income tax, corporation tax, capital gains tax, national insurance contributions and inheritance tax

• Indirect taxes are imposed on spending

  • The less a consumer spends, the less indirect tax they pay

  • Examples of indirect tax include Value Added Tax (19% VAT rate in the European Union in 2022), taxes on demerit goods and excise duties on fuel

Progressive, regressive and proportional tax systems 

• Tax systems can be classified as progressive, regressive or proportional

• Most countries have a mix of progressive (direct taxation) and regressive (indirect taxation) taxes in place

Progressive tax system

• As income rises, a larger percentage of income is paid in tax

• In the diagram, when personal income rises from Y₁ to Y2, the tax rate rises from T₁ to T₂

Regressive tax system

• Indirect taxes are regressive in terms of proportion of income

  • A high earner and a low earner pay the same absolute amount of VAT on a good, but it represents a larger share of the low earner's income.

    • As income rises, a smaller percentage of income is paid in tax

• In the diagram, when personal income rises from Y₁ to Y2, the tax rate falls from T₁ to T₂

• All indirect taxes are regressive

• In the USA, Federal income tax is progressive but almost all State taxes are regressive (the bottom 20% of income earners pay as much as 6x the % of their income than the top 20%)

Proportional tax system

• As income rises, the same percentage of income is paid in tax

• In the diagram, when personal income rises from Y₁ to Y2, the tax rate remains constant at 20%

• In 2022, Bolivia was using this system with a proportional tax rate of 13%

Marginal and average rates of taxation (mrt, art)

• Marginal rate of tax (MRT) is the proportion of each additional dollar of income taken in tax - the rate paid on the last unit of income earned

  • In a progressive tax system, marginal tax rates increase as income increases

• Average rate of tax (ART) is the proportion of total income taken in tax - total tax paid divided by total income

• Direct tax rate calculations usually focus on the calculation of marginal and average tax rates from a set of data provided

• Average tax rates are calculated using the following formula

Reasons for taxation

• Nearly every economy in the world is a mixed economy and has varying degrees of government intervention

• One of the main reasons that governments tax is to correct various market failures

• To raise revenue

  • The primary purpose of most taxes is to fund government expenditure on public goods, merit goods and transfer payments

  • Without tax revenue, governments could not provide national defence, education, healthcare or social security

• To redistribute income and wealth

  • Progressive taxes take a higher proportion of income from higher earners, reducing inequality and improving equity

  • Income tax and inheritance tax are used explicitly for this purpose in most economies

• To correct market failure

  • Indirect taxes on demerit goods and goods generating negative externalities aim to internalise external costs and reduce consumption towards the socially optimal level

  • Examples include taxes on tobacco, alcohol and carbon emissions

• To discourage certain behaviours

  • Closely related to market failure correction, governments use taxation to reduce consumption of harmful goods where the social cost exceeds the private cost

• To manage aggregate demand and achieve macroeconomic objectives

  • Taxation is a tool of fiscal policy; raising taxes reduces household disposable income and firm profits, contracting aggregate demand during periods of high inflation