Characteristics of effective tax systems

Governments collect taxes to fund public spending, but taxes also serve wider purposes, such as influencing social outcomes like income distribution. For a tax system to work well, it needs specific features that make it practical and fair.

Key features of a good tax system

• Cost-effective collection - Taxes should be inexpensive for the government to gather.
• Ease of payment - Individuals and businesses should find it straightforward to pay what they owe.
• Difficult to evade - Systems should minimise opportunities for avoidance or illegal non-payment.
• No negative incentives - Taxes should not discourage desirable behaviours, such as working hard or saving money.

Governments also design taxes to promote broader goals, like reducing income gaps. This can involve using tax revenue to fund benefits or public services.

Direct and indirect forms of taxation

• Direct taxation - Levied straight on income or wealth, such as income tax, where the amount paid depends on earnings.
• Indirect taxation - Added to the price of goods and services, like value-added tax (VAT) or excise duties on items such as fuel or alcohol.

Horizontal and vertical equity in taxation

Equity in taxation ensures that the system treats people fairly based on their circumstances. Governments often aim for this to build trust and achieve social objectives.

Principles of tax equity

• Horizontal equity - People with similar incomes and ability to pay should contribute the same amount in taxes, preventing unfair differences among equals.
• Vertical equity - Those with higher incomes and greater ability to pay should contribute more than those on lower incomes, reflecting the idea that taxes should match financial capacity.

Achieving both types of equity helps promote overall equality in the economy, such as by using taxes to narrow disposable income differences or to finance public services.

Types of tax systems: progressive, regressive, and proportional

Governments choose tax systems to meet specific goals, such as redistributing wealth or boosting economic activity. The three main types differ in how the tax burden changes with income levels.

Progressive taxation

In progressive systems, the percentage of income paid in tax increases as earnings rise.

Purpose and effects:

• Often used to redistribute income from the wealthy to the less well-off, reducing poverty and increasing equality.
• Revenue can fund benefits or merit goods like healthcare and education.
• Follows the 'ability to pay' idea, ensuring vertical equity where higher earners contribute more proportionally.

Regressive taxation

In regressive systems, the percentage of income paid in tax decreases as earnings rise.

Purpose and effects:

• Aims to stimulate supply-side growth by leaving more money with higher earners, who might invest it in businesses (the trickle-down effect).
• This can incentivise harder work but may widen inequality.
• Can create disincentives if taxes are too high, potentially reducing overall government revenue.

Proportional taxation

Proportional systems, or flat taxes, apply the same tax percentage to everyone, regardless of income.

Advantages:

• Simplifies the system.
• Reduces evasion incentives (especially for high earners who pay less than in progressive systems).
• Encourages earning more without facing higher rates.

Disadvantages:

• Lacks vertical equity, as the flat rate may burden low earners disproportionately.
• Generates less revenue than variable systems.
• Can be adjusted for progressivity with a tax-free allowance, where no tax is paid below a certain income threshold.

Challenges in implementation:

• Setting a single fair rate is difficult, as it might be unaffordable for the poor while not raising enough from the rich to cover public goods and services.

The Laffer curve and its implications

The Laffer curve illustrates the relationship between tax rates and government revenue, highlighting how excessive taxation can backfire.

The Laffer curve

The Laffer curve is an inverted U-shaped graph plotting tax revenue against tax rates from 0% to 100%.

Key features:

• Rising section - As tax rates increase from 0%, revenue grows because more money is collected per unit of income, with people still motivated to work.
• Peak point - Represents the optimal tax rate where revenue is maximised.
• Falling section - Beyond the peak, higher rates discourage work and economic activity, leading to lower overall revenue.
• Extreme ends - At 0%, no revenue is collected; at 100%, revenue is also zero because no one would work under full taxation.

Implications for tax policy

Supply-side economists use the curve to argue that high direct taxes reduce incentives to work, ultimately lowering revenue. Governments might cut rates past the peak to boost motivation and increase total collections.

Taxation in the UK - VAT and income tax

The UK employs a mix of taxes to balance revenue needs with economic and social goals. Debates exist over whether the overall system is progressive or regressive.

Value-added tax (VAT)

VAT is a sales tax applied to most goods and services at a fixed percentage, making it proportional.

Regressive aspects:

• It can act regressively because lower earners spend a higher proportion of their income on taxable items (while higher earners save more).
• This means the poor pay a larger share of their income in VAT.

Potential for progressivity:

• Charging higher rates on luxury goods could make VAT more progressive, targeting those who can afford expensive items.

Income tax system

The UK income tax is structured progressively.

Tax rates:

• Tax-free allowance - No tax on earnings up to a set amount (e.g., £12,500 for 2019/20).
• Basic rate - 20% on income above the allowance for low-to-middle earners.
• Higher rates - 40% for high earners above a threshold, and 45% for very high earners above a further limit.

Overall UK tax system

Combining direct (e.g., income tax) and indirect (e.g., VAT) taxes, the system is argued to be regressive, as the lowest earners pay a higher proportion of their income in total taxes compared to the highest earners.