4.5.2 Taxation

• Proportional tax


  A fixed rate for all tax payers, regardless of income. Also called a flat tax.
• Proportional tax


  • All tax payers might have to pay 20% income tax rate
• Incidence of proportional taxes

  Equal, regardless of the ability of the taxpayer to pay
• Proportional tax


  Could encourage people to earn higher incomes, because the rate of tax paid does not increase
• Progressive tax


  An increase in the average rate of tax as income increases. The proportion of income taxed increases as income increases.
• Progressive tax in the UK

  • Personal allowance of £10,600 where tax is not paid
  • Incomes below £31,785 pay basic rate of 20%
  • Incomes between £31,786 and £150,000 pay higher rate of 40%
  • Incomes above £150,000 pay 45% rate
• Purpose of progressive tax

  Help reduce inequality, because those on lower incomes pay less tax
• Basis of progressive tax


  The payer's ability to pay. Higher income households are more able to pay higher rates of tax than lower income households.
• Generally, direct taxes are more progressive
• Regressive tax


  Does not relate to income, but means those on lowest incomes have a higher average rate of tax. The proportion of income paid as tax is higher for those on lower incomes than those on higher incomes.
• Regressive taxes


  • London Congestion Charge
  • Council Taxes
• Regressive taxes lead to a less equitable distribution of income
• Generally, indirect taxes are more regressive
• Laffer curve


  Shows how much tax revenue the government receives at each level of tax. Up until the point 'T', as tax rates increase, government tax revenue increases. After point 'T', people do not think it is as worthwhile working, and the lack of incentive to work leads to falling tax revenue. 'T' is the optimum tax rate where the government can maximise their revenue.
• Laffer's argument


  Tax rates are too high, so they provide a disincentive to work. To encourage people to work harder, tax rates should be reduced.
• Income redistribution


  Government intervention can lead to income redistribution and wage equality, e.g. inheritance tax means rich families cannot keep their entire wealth.
• Over the last 2-3 decades, the UK has switched towards indirect taxes, which tend to be more regressive than direct taxes
• The top income tax rate fell from 83% in 1979 to 40% in 1988, and it is still at this rate today
• The basic income tax rate fell from 33% to 22%, which helps workers keep more income. However, the benefits of this disproportionately favour the richest households, leading to a worsening of the income distribution.
• Expansionary fiscal policy


  Governments increase spending or reduce taxes to increase aggregate demand. It leads to a worsening of the government budget deficit, and it may mean governments have to borrow more to finance this.
• Deflationary fiscal policy


  Governments cut spending or raise taxes, which reduces consumer spending. It leads to an improvement of the government budget deficit.
• Indirect taxes


  Could cause cost push inflation if producers choose to pass the costs onto the consumer
• Taxes on imports (tariffs)


  Make it more expensive to import goods, which should, in theory, improve the trade balance. However, other countries might retaliate, so exports might decrease as well.
• Competitive tax environment to encourage FDI

  Taxes should be consistent and predictable, so they are business friendly. This would encourage FDI flows. High, fickle taxes are likely to discourage FDI flows, since investors will choose to invest elsewhere.