Funding public expenditure (like building roads or hospitals) is one of the reasons why governments collect taxes. The government uses the collected revenue to achieve certain economic goals including manipulating aggregate demand levels. A government also uses taxation for the redistribution of income in an attempt to lower income inequality and create a more equitable society.
Albert Einstein once said
The hardest thing in the world to understand is the income tax.
Although taxation might seem like a difficult concept to understand, we will explain the different types of taxes and tax systems in detail. We will also discuss why taxation is important for a country’s economy.
Taxation
When a government imposes a compulsory levy on its residents and citizens to pay for its activities. Taxation is the main source of revenue for most national governments. The government also receives other non-tax income in the form of interest and dividends.
Direct and indirect taxation
Direct and indirect taxation
We can divide taxation into two main categories: direct and indirect.
Direct taxes
Direct taxes are taxes imposed by the government on the various forms of income, capital, and wealth. Some types of direct taxes are:
Income taxThis type of tax is paid on salaries, wages, savings, and property. For instance, when you work and earn a salary, you have to pay taxes according to the amount you earn. In the UK, you get a personal allowance, which means that the first income tax band (up to £12,570 per year) is tax-free. Income tax is levied on income between £12,570 and £50,270. For example, if you earn £40,000 a year, the first £12,500 would be tax-free, but the remaining £27,430 would be taxed at 20%.
National insurance contributions National insurance contributions can be regarded as another aspect of income tax. They are a form of social security and help pay for state benefits for when individuals need help. In the UK these contributions are used to fund the National Healthcare Service (the NHS).
Corporate taxesCorporate taxes are a form of tax that companies pay on their profits. The corporate tax rate in the UK is currently at 19%.
Capital gains taxCapital gains tax is a form of tax levied on selling assets and investments. For example, if you bought a house ten years ago for £150,000 and you sell it today for £500,000, you would pay tax on the increase in value.
Inheritance taxInheritance tax is a type of tax you pay on wealth when a person dies and leaves assets behind for you.
Council taxCouncil tax is a type of tax paid to your local council based on the value of the property you live in.
Indirect taxes
The government imposes indirect taxes on spending. Indirect taxes include the following:
Value-added tax (VAT)Most goods and services charge this tax. In the UK, the VAT rate is 20%. VAT is set at a lower rate (5%) for certain goods and services like home electricity or children’s car seats. Other goods and services, such as basic food items or books, have a zero rate (0%) VAT charge.
Excise dutyExcise duty is a form of tax paid on certain goods that the government considers harmful for consumption or the environment. This duty is levied on goods made in the UK in addition to imported goods. Excise duty is paid on products like alcohol, alcohol-containing goods, tobacco products, petrol, diesel, and biofuels.
Taxation systems
A government can implement different types of tax systems to bring equity to the distribution of income and wealth. The nature of taxation can be progressive, proportional, or regressive.
Progressive
The progressive tax system is where higher-income earners have higher tax rates. A government uses this type of system to reduce inequalities and make the distribution of income more equitable.
Progressive taxes reduce the spending power of higher-income earners and increase the spending power of lower-income earners. In the UK, the income tax burden increases as you earn more: higher earners take on more of the tax burden.
Progressive tax systems result in the formation of tax bands or brackets (as explained in the income tax section above). Take a look at the current tax bands in England as an example:
Tax band | Taxable income | Tax rate |
| Personal allowance | £0 - £12,570 | 0% |
| Basic rate | £12,571 - £50,270 | 20% |
| Higher rate | £50,271- £150,000 | 40% |
| Additional rate | £150,000 + | 45% |
Table 1. Tax rates and allowances.
Regressive
The regressive taxation system is essentially the opposite of progressive taxation. Regressive taxation takes a larger percentage of income from lower-income earners than from higher-income earners. In this system, lower-income earners take on more of the tax burden. The regressive tax system is used for certain types of taxes like excise duty.
For example, a higher-income earner is taxed indirectly less than a lower-income earner when purchasing alcohol.
When purchasing alcohol (a good on which the excise duty is charged), a higher income earner is indirectly taxed less than a lower income earner. Let’s say the price of a wine bottle is £10 out of which £ 5 is tax. This price is the same for everyone no matter their income. For someone earning £10 an hour, this tax is 50% of their hourly wage, whereas for someone earning £50 an hour the tax is only 10% of their hourly wage.
Proportional
The proportional taxation system is a system where everyone has the same percentage of tax levied no matter their income. This rate is also known as a flat rate.
Let’s say that the flat rate is 20%, meaning an individual who earns £1,000 will have to pay 20% in income taxes, and someone earning £100,000 will also have to pay 20% in income taxes.
Some people argue that his type of tax system incentivises people to earn more, as they are not charged higher rates as due to higher income.
The nature of taxation in the UK
Figure 1 shows that a large percentage of people's income is paid in taxes. Income tax is one of the main sources of government revenue in the UK, making up almost half of the public sector receipts in the year 2021/2022. This is a form of direct taxation.
Taxes on spending such as the VAT and fuel duty also make up a large percentage (18.3%) of government revenue, but it is significantly smaller than the tax revenue earned on income. These are both examples of indirect taxes.
Fig. 1 - Expected public sector revenue 2021–22. Source: obr.uk
Calculation of tax rates
To identify whether a tax is progressive, regressive, or proportional, we can take a look at the relationship between the average and marginal tax rates.
Average tax rate
The formula for calculating the average tax rate is the following:
If a person earns £50,000 and pays £10,000 in taxes, the average tax rate would be 20%.
Marginal tax rate
The marginal tax rate is the rate of tax you pay on an additional unit or an additional £1 of income. The formula for calculating the marginal tax rate is:
If the same person now earns £57,000 and pays £ 11,000 in taxes, the marginal tax rate is 28.6%.
In progressive systems, the average tax rate is lower than the marginal rate. In regressive tax systems, the average tax rate is higher than the marginal rate. This is because the proportion of income paid in taxes (average rate) decreases as income increases. In the case of a proportional tax system, both the average and marginal rates are equal.
The relationship between tax systems and tax rates
By calculating the average tax rate we can see the overall burden of the tax on the taxpayer, whereas the marginal rate can be used as an indicator for decision making.
The marginal tax rate is a significant factor when it comes to making decisions about work and leisure, which influences the supply of labour. Suppose the marginal tax rate increases significantly, leading to a highly progressive tax system. In that case, people (especially high-income earners) will choose to work less as being taxed more heavily disincentivises them from working more. This decreases the supply of labour in the economy.
Additionally, high marginal tax rates also reduce saving, which has a negative impact on investment in the economy. A lower supply of labour and investment can result in reduced growth rates in the economy.
Principles of taxation
Adam Smith's principles of taxation, also known as canons of taxation, argue that taxes should be:
Equitable: the tax system should be fair based on everyone’s ability to pay.
Economical: the tax should be cheap to collect.
Convenient: the tax should be convenient for taxpayers to pay.
Certain: the taxpayer should be certain of the amount of tax they are due to pay.
Furthermore, we could add the principles of efficiency and flexibility. The idea of efficiency suggests that the tax should achieve its desired objectives and flexibility implies that the tax should be relatively easy to change in case new circumstances arise.
According to Adam Smith's principles of taxation, a relatively well-designed tax should meet many of the principles outlined above, whereas a relatively badly designed tax meets only a few of the principles.
Taxation - Key takeaways
Taxation is when a government imposes a compulsory levy on its residents and citizens to pay for its activities. It is the main source of revenue for most national governments.
Direct taxes are taxes imposed by the government on various forms of income and include taxes like corporate tax, income tax, or capital gains tax.
Indirect taxes are imposed by the government on spending and include taxes like VAT and excise duty.
The progressive tax system is a system in which higher tax rates are imposed on higher-income earners.
The regressive taxation system is essentially the opposite of progressive taxation. Regressive taxation takes a larger percentage of income from lower-income earners than from higher-income earners.
The proportional taxation system is a system in which the same percentage of tax is levied on everyone's earnings no matter their income. This rate is also known as a flat rate.
The average tax rate is calculated by dividing the amount of tax paid by income.
The marginal tax rate is calculated by dividing the change in tax paid by the change in income.
The marginal tax rate is a significant factor when it comes to making decisions about work and leisure, influencing the supply of labour in the economy.
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