Taxation and the economy

There are essentially two types of taxes – direct taxes and indirect taxes.

Direct taxes

Direct taxes are those imposed on individuals and firms at the point at which they earn income.

For individuals, these taxes are commonly called ‘income tax’. For firms, direct taxes are those imposed on ‘net’ incomes, and are variously called business tax, company tax, corporate tax, or corporation tax.

Indirect taxes

In contrast, indirect taxes are those that are paid when individuals or firms make purchases, such as sales taxes and value added tax (VAT).

Indirect taxes may be levied at the national or Federal level, or at the local, or State level, depending on the political system.

In the US, for example, States are free to set their own sales taxes, and there is no general Federal sales tax. In contrast, in India there is both a central and local sales tax (Central Sales Tax and Sales Tax respectively).

VAT

Value added tax (VAT) is one of the most common types of indirect tax and involves placing taxes on the value added by firms at each stage in the process of production.

The tax is passed along the chain until the final consumer pays a price which includes the VAT.

Typically, not all products incur VAT, such as merit goods like education and health services and products, and essential services such as food.

Some products have lower rates to reduce the impact of regressiveness, such as domestic energy supply. For example, in the UK, domestic energy is charged at 5% compared with the basic rate of 20%, and in Germany the reduced rate is 7%, compared with the basic rate of 19%.

Typically, in most advanced economies, government revenue comes largely from taxes on incomes, followed by sales tax or VAT.

Advantages and disadvantages of different types of tax

In the late 18th Century, Scottish economist Adam Smith provided the first attempt to evaluate taxes and tax systems. Smith argued (in The Wealth of Nations, 1776) that ‘good’ taxes would be:

Efficient in terms of how easy they would be to collect with low costs of collection. Generally, the collection of direct taxes is made convenient through systems which reduce collection costs. For example, payroll taxes are automatically calculated by firms using software. Individuals can also use online ‘self-assessment’ methods.

Convenient, in that the taxpayer should not be required to make undue effort or take up excessive time to make tax payments. For direct taxes, self-assessment schemes make it relatively straightforward for individuals to calculate their tax due, and online payments systems make paying tax relatively convenient.

Certain, so that taxpayers should know in advance how much tax they will have to pay, and taxes should not be set in an arbitrary way.

Fair in terms of reflecting the ability to pay of taxpayers - a good tax system should not impose an unfair burden on one section of society and taxes should, therefore, be ‘equitable’ in their impact.

In addition to Smith’s ‘canons’ we can add the following requirements for a ‘good’ tax or tax system in the 21st Century, namely that taxes should:

Promote welfare - taxes should be capable of encouraging ‘wanted’ behaviour and discouraging ‘unwanted’ behaviour, such as using ‘sin’ (or Pigouvian) taxes to reduce cigarette smoking and alcohol consumption, or to reduce pollution, or conserve non-renewable scarce resources, and other environmental objectives.

Maximise revenue to the government – taxes should not encourage individuals to avoid or evade direct taxes, or to reduce their effort or supply of labour by creating a disincentive to work. Similarly, in terms of indirect taxes, governments should take into account the significance of price elasticity of demand for products to avoid a tax having an excessively negative impact on sales, revenue to firms and, of course, revenue to itself. (see the Laffer curve).

Be useful as a macroeconomic policy tool – taxes can be used, along with government spending, to stimulate or constrain aggregate demand, or improve supply-side performance.

Help redistribute income or wealth – while Adam Smith referred to ‘fairness’, modern tax systems often go one step further by helping to redistribute income or wealth between different groups. The aim of this is to reduce inequality. (see the Lorenz curve).

Progressive, proportional and regressive taxes

Taxes can be analysed in terms of their impact on the disposable incomes of individuals and households. The 'progressiveness' of a tax refers to the proportion of income going in tax. There are three ways to describe the relationship between income and tax:

    Progressive taxes are those where the proportion of tax paid rises with income.
    Proportionate taxes are those where the proportion of tax paid is constant as income changes.
    Regressive taxes are those where the proportion of tax paid increases with income.

Direct taxes can be made progressive

One key advantage of direct taxes is that they can be made progressive. Progression can be achieved by increasing tax rates progressively as income (or wealth) increases. Consider the hypothetical example below:

Tax system example

The tax payable for an individual receiving an income of 120,000 would be:

Tax system example

In this case, the individual would pay 22.00% of their income in tax. (26,500/120,000).

Using the same tax bands, the tax paid by two other individuals, one earning just 12,000 and the other earning 200,000 would be:

Tax system example

In the case of the lowest paid, individual would pay only 3.33% of their income in tax. (400/12000)

Tax system example

In the case of the highest paid, the individual would pay 25.25% of their income in tax. (50,500/200,000)

So, this system is progressive, with the lowest income earners paying less than one % of their income in tax, compared with the highest income earner who pays just over a quarter of their income in tax.

Hence, one compelling benefit of direct taxes is that they can be made to be progressive, and help reduce the gap between rich and poor.

Indirect taxes are generally regressive

However, indirect taxes are, by their nature, regressive in that they are based on spending and not income.

For example, consider the same three individuals in terms of spending on a taxable TV subscription, at, say [$/£/or€] 100 a year, which includes a 20% tax. The percentages paid in tax would, in this case, fall with income, making it regressive – as shown below:

Tax system example

Of course, individuals with higher incomes are likely to spend much more and pay more in indirect taxes, but as a proportion of income, the burden will fall more heavily on the poor.

Conflicts, trade-offs and limitations

We can use all the above criteria to assess taxes and tax systems and see conflicts and trade-offs between them.

For example, while an indirect tax on cigarettes may be efficient to collect, and can reduce cigarette consumption, it may be regressive in its impact.

Alternatively, while a direct tax may be progressive it may not deter unwanted behaviour and may actually encourage tax avoidance.

In wider terms, the tax system can be adjusted to help achieve specific objectives at certain points in time or at points in the business cycle.

Taxes can be used to help reduce unemployment, control inflation, help promote growth and achieve improvements in the balance of payments. (see tariffs).

While general taxes (and subsidies) are the long established and accepted way of achieving economic objectives, behavioural economists often argue that objectives can also be achieved by smaller ‘nudges’.

These might include signs, signals and images that can influence behaviour and encourage individuals to reduce consumption of harmful products and increase the consumption of beneficial ones. For example, governments requiring stores to place cigarettes out of sight, or forcing food producers to clearly label their products to indicate any chemical additives and the calorific value of their products.

Taxation and the Covid crisis

The Covid pandemic is a very current example of how taxes, subsidies and behavioural theories have been (and are being) used to help deal with the economic consequences of the crisis.

Changing behaviour during the Covid pandemic has relied as much on images and signs (2 meter distancing, hand washing etc.), and legislation regarding lockdowns, than on traditional taxes and subsidies.

Most governments have used subsidies and tax relief to assist firms and individuals cope better with the economic effects of the pandemic.

Changes in the UK are typical of those introduced across the globe, including:

  1. Optional deferral of VAT payments of required until June 2020.
  2. A temporary 5% reduced rate of VAT on goods and services related to hospitality, hotel and holiday accommodation, and admission to certain attractions – ending in January 2021.
  3. Optional deferral of income tax payments until January 2021.
  4. Allowing time to pay corporation tax.
  5. Waiver of import taxes on vital medical supplies.
  6. Affected business may also be able to request additional relief (in the UK, called ‘Hardship Relief’).
  7. A temporary cut in ‘stamp duty’ (a tax on property transactions) to zero on purchases of homes of up to £500,000 in England and Northern Ireland.

Impact on public finances

What is clear is that the public sector finances will suffer considerably from the increase in government support and the fall in tax revenue as an immediate and direct result of the pandemic itself. In addition the indirect effects are likely to continue into the medium term as businesses fail and unemployment increases.

It is also clear that tax policy may need a rethink, with the inevitable conclusion that taxes will have to be raised to offset increasing public sector debt levels.

The effect of a cut to business taxes

Tax cuts on business, including corporation tax, may have several macroeconomic and microeconomic effects.

In terms of microeconomic effects, tax cuts on businesses may result in the following:

Profits

Firms will be able to retain more profits, which can be used to increase investment and research and development. However, there is no guarantee that this will happen, and profits may simply be distributed to shareholders.

New products and markets

Firms may enter new markets and development new products.

Economies of scale

The growth of firms may enable it to benefit from economies of scale, and reduce costs further.

Prices

Firm may pass on some of the tax reduction to consumers in terms of lower prices, which will increase consumer surplus.

From a macroeconomic perspective, tax cuts on businesses may have the following effects:

Net injection

Taxes are a withdrawal out of the circular flow of income, so when they are reduced there is effectively a ‘net injection’, hence the circular flow will increase.

Aggregate demand

Aggregate demand is likely to increase, which is likely to lead to growth in national output and employment.

Diagrammatically, the increase in aggregate demand will shift the AD curve to the right.

There may be upward pressure on the price level.

Increasing productivity

Aggregate supply

On the supply-side, the tax cut can be seen as a reduction in business costs, which shift the SRAS to the right. Again, the effect of this is likely to raise equilibrium output as AD expands. Tax cuts are seen as a supply-side policy, which will create incentives for existing businesses to expand, and for new businesses to start-up.

Trade

In addition, there may be an effect on the trade balance, given that imports are a function of national income. Any fiscal stimulus following tax cuts may increase imports relative to exports and worse the trade balance. Set against this is the possibility that inward FDI will increase as foreign investors look to take advantage of lower-tax regime.

Offsetting costs

However, tax is a key source of revenue to a government, and although taxes on business tend to be relatively small in terms of total tax receipts, any reduction is revenue may need to be met by either higher taxes elsewhere, by borrowing, or by reducing government services.

Those in favour of such tax reductions will argue that if the economy grows as a result then tax revenues will increase in general as a result of fiscal drag. Furthermore, supply-side economists might point to fact that the incentive effect of reducing tax rates could lead to a rise in government revenues, and not a fall – as suggested by the Laffer curve.

Revenue could increase following a tax cut

Further reading: Covid and tax reform

Sources:

UK government

Institute of Fiscal Studies

Financial Times