Taxation (Cambridge (CIE) IGCSE Economics): Revision Note

The classification 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

• 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%

The impact of taxation

Impact on consumers

• Higher prices

  • Indirect taxes increase the price of goods and services, reducing consumers’ purchasing power

• Reduced consumption

  • Higher prices may cause people to buy less, especially for non-essential goods

• Behaviour changes

  • High taxes on harmful goods (e.g. cigarettes) can discourage consumption

• Lower disposable income

  • Direct taxes (e.g. income tax) reduce the amount of income consumers can spend or save

Impact on workers

• Lower take-home pay

  • Income tax reduces the amount workers keep from their wages

• Reduced incentive to work

  • Higher taxes may discourage overtime or seeking higher-paid jobs

• Impact on employment

  • If firms cut costs to pay higher taxes, jobs may be lost or wage growth may slow

Impact on producers/firms

• Higher costs of production

  • Indirect taxes (e.g. VAT) make production more expensive

• Reduced sales

  • Higher prices can lower demand, especially for price-sensitive goods

• Lower profits

  • Increased costs and reduced sales can reduce profitability

• Business decisions

  • Firms may relocate to countries with lower taxes or invest less in expansion

Impact on the government

• Revenue generation

  • Taxation is the main source of government income for funding public services (e.g. healthcare, education)

• Economic control

  • Taxes can discourage harmful consumption (e.g. sugar tax) or reduce imports (e.g. tariffs)

• Redistribution of income

  • Progressive taxes (higher rates for higher earners) can reduce income inequality

Impact on the economy

• Reduced spending and investment

  • High taxes can slow economic growth if they reduce consumption and business activity

• Inflationary pressures

  • Indirect taxes can raise prices, contributing to inflation

• Improved public services

  • Tax revenue allows the government to invest in infrastructure, education and healthcare, which can boost productivity in the long term

• Balancing effects

  • The overall impact depends on tax rates, how revenue is used and the state of the economy