Direct and indirect taxes

Taxes are compulsory payments made to the government, and they fall into two main categories based on how they are applied.

Direct taxes

Direct taxes are imposed on income and wealth. They are paid directly by individuals or organisations to the government.

Examples of direct taxes:

• Income tax, which is charged on personal earnings.
• Corporation tax, which is applied to company profits.

Indirect taxes

Indirect taxes are levied on the sale of goods and services. They are collected by businesses but are mostly passed on to consumers through increased prices. The extent to which the tax burden is shifted to consumers depends on the price elasticity of demand for the product – if demand is inelastic, consumers bear more of the cost.

Common forms of indirect taxes:

• Value added tax (VAT) and general sales tax (GST) - These are ad valorem taxes, calculated as a percentage of the product's price.
  • For example, the standard VAT rate in Sweden is 25%, while Australia's GST is 10%.
• Specific indirect taxes - These involve a fixed amount per unit of the product.
  • For example, a government might charge £0.80 per litre of petrol.
• Excise duties - Taxes applied to specific items.
• Sin taxes - Levied on products that can harm health, aiming to reduce their consumption.
  • For example, countries like Canada, Norway, and Singapore tax sugary drinks.

Advantages and disadvantages of indirect taxes

Governments are increasingly using indirect taxes as a source of revenue. Compared to direct taxes, they have distinct benefits and drawbacks.

Advantages of indirect taxes

• They can be adjusted rapidly.
• Collection costs are lower because businesses handle much of the paperwork.
• They can target and discourage the purchase of particular items.
• Unlike direct taxes, they do not reduce incentives for work, creativity, or saving.

Disadvantages of indirect taxes

• They are regressive, taking a bigger share of income from those on lower earnings.
• They may contribute to inflation by raising production costs (cost-push inflation).
• They can lead to tax evasion or smuggling to avoid payment.

Progressive, regressive, and proportional taxes

Taxes can be classified based on how the tax burden changes with income levels, affecting fairness and economic behaviour.

Progressive taxes

Progressive taxes take a higher percentage of income as earnings increase. They aim to reduce inequality by placing a greater burden on higher earners.

Regressive taxes

Regressive taxes take a lower percentage as income rises, meaning they disproportionately affect those with lower incomes. Flat-rate systems can often be regressive in practice.

Proportional taxes

Proportional taxes apply a fixed percentage to all income levels, regardless of how much is earned.

Example of a progressive tax system

In this system, someone earning £30,000 pays £2,700 in tax (15% of £18,000), which is 9% of their total income. Someone earning £55,000 pays £13,200 (£2,700 + 30% of £20,000 + 40% of £5,000), which is 24% of their income.

Marginal and average rates of taxation

Tax rates can be viewed in terms of additional income or overall earnings, which helps in understanding their impact on incentives and fairness.

Marginal rate of taxation

The marginal rate of taxation is the proportion of any extra income that is taken as tax.

For example, if someone earns an additional £300 and £90 is taxed, the marginal rate is 30%.

Average rate of taxation

The average rate of taxation is the proportion of total income paid in tax.

For example, if total earnings are £40,000 and tax paid is £8,000, the average rate is 20%.

Relationship between marginal and average rates

• In progressive taxes, the marginal rate exceeds the average rate.
• In regressive taxes, the marginal rate is below the average rate.
• In proportional taxes, the marginal and average rates are equal.

Worked example - Calculating marginal and average tax rates

A person earns £38,000 and pays £7,600 in tax. They then receive a bonus of £600, on which they pay £210 in tax. Calculate the marginal tax rate on the bonus and the average tax rate on the new total income.

Step 1: Identify the values

• Original income = £38,000
• Original tax = £7,600
• Bonus = £600
• Tax on bonus = £210

Step 2: Calculate marginal tax rate

$\text{Marginal tax rate}=\frac{210}{600}\times 100=35\%$

Step 3: Calculate new total income and tax

• New total income = £38,000 + £600 = £38,600
• New total tax = £7,600 + £210 = £7,810

Step 4: Calculate average tax rate

$\text{Average tax rate}=\frac{\mathrm{7,810}}{\mathrm{38,600}}\times 100=20.2\%$

Reasons for taxation and tax systems

Governments use taxes for multiple purposes, from funding services to shaping economic activity. Different systems exist to balance simplicity and equity.

Purposes of taxation

• To generate revenue for spending on merit goods (like education) and public goods (like national defence).
• To manage aggregate demand, such as raising taxes to curb spending during high inflation.
• To redistribute income more fairly, often through progressive taxes funding welfare programmes.
• To deter consumption of demerit goods (like tobacco) or imports.

Features of tax systems

Some countries adopt flat-rate tax systems, applying a single rate across various taxes for simplicity, though this can be regressive.

For example, a nation might set a 20% rate for income tax, corporation tax, and sales tax. Countries like Hungary and Lithuania have tried versions of flat taxes on earnings.