3.17 - Taxation, Poverty & Inequalities
Types of taxes
Taxes are compulsory payments to the government used to fund public services and influence economic behaviour. They are divided into direct and indirect categories based on how they are collected.
Direct taxes
Direct taxes are paid straight to the tax authorities by individuals or organisations.
Examples of direct taxes:
- Personal income taxes - Levied on various forms of income, including wages, rental income, interest, and dividends.
- Corporate income taxes - Applied to the profits earned by companies.
- Wealth taxes - Imposed on the ownership of assets, such as property taxes on homes or inheritance taxes on estates passed to heirs.
Indirect taxes
Indirect taxes are added to the price of goods and services, with consumers paying them through sellers. These include value-added tax (VAT) on purchases, where the tax is built into the final price paid by the buyer.
Progressive, proportional, and regressive taxes
Taxes can be classified by how the tax burden changes with income levels, affecting fairness and economic equality.
Progressive taxes
In a progressive tax system, individuals with higher incomes pay a larger percentage of their income in tax. As income rises, the proportion paid as tax increases.
Example: If Anna earns £25,000 and pays £3,750 in tax (15%), while Ben earns £60,000 and pays £18,000 (30%), the system is progressive because Ben pays a higher rate.
Proportional taxes
In a proportional tax system, all individuals pay the same percentage of their income in tax, regardless of earnings. The proportion remains constant as income changes.
Example: If Anna pays £3,750 on £25,000 (15%) and Ben pays £9,000 on £60,000 (also 15%), the system is proportional.
Regressive taxes
In a regressive tax system, individuals with higher incomes pay a smaller percentage of their income in tax. As income rises, the proportion paid as tax decreases.
Example: If Anna pays £3,750 on £25,000 (15%) and Ben pays £6,000 on £60,000 (10%), the system is regressive.
Indirect taxes are often regressive because they take a larger share of lower incomes. For instance, if both Anna and Ben pay £200 VAT on a £1,000 appliance (20% rate), this is 0.8% of Anna's income but only 0.33% of Ben's. Income taxes, however, are never regressive.
Average and marginal tax rates
Tax rates can be measured in average or marginal terms to analyse the overall burden and the effect of income changes.
Average tax rate
Where:
- Total tax paid = Amount of tax (£)
- Total income = Earnings before tax (£)
This shows the overall percentage of income paid in tax.
Marginal tax rate
Where:
- Change in tax paid = Increase in tax (£)
- Change in income = Increase in earnings (£)
This measures the tax rate on additional income.
Calculating tax in progressive systems
Progressive systems use income brackets, where different portions of income are taxed at varying rates. Total tax is calculated by applying each rate only to the income within that bracket.
Example tax brackets:
- £0–£18,000: 10%
- £18,001–£38,000: 20%
- £38,001–£58,000: 28%
- £58,001 and above: 32%
Worked example - Calculating total tax in a progressive system
An individual earns £45,000 annually. Using the tax brackets above, calculate the total tax paid.
Step 1: Identify the values
- Income = £45,000
- Brackets and rates:
- £0–£18,000: 10%
- £18,001–£38,000: 20%
- £38,001–£58,000: 28%
Step 2: Apply rates to each bracket
- First £18,000 at 10% = £18,000 × 0.10 = £1,800
- Next £20,000 (£18,001–£38,000) at 20% = £20,000 × 0.20 = £4,000
- Remaining £7,000 (£38,001–£45,000) at 28% = £7,000 × 0.28 = £1,960
Step 3: Calculate total tax
Total tax = £1,800 + £4,000 + £1,960 = £7,760
How taxation and other policies reduce poverty and inequality
Governments use taxation and additional policies to redistribute income and wealth, aiming to reduce poverty and economic disparities.
Taxation methods to reduce inequality
- Progressive income taxation - Higher earners pay more, redistributing wealth to fund services for lower-income groups.
- Wealth taxes - Taxing assets like property or inheritances forces the richest to contribute more.
- Progressive property taxes - Increasing rates on higher-value properties to target wealthier owners.
- Reduced reliance on indirect taxes - Minimising these regressive taxes to avoid disproportionately burdening the poor.
Research on inequality and taxation - Saez and Piketty
- Method - Analysed tax data over decades to track wealth distribution.
- Results - The top 0.1% of Americans held 19.3% of wealth in 2018, three times their share from 40 years earlier, driven by tax cuts since 1980.
- Conclusions - Tax reductions for the wealthy have significantly increased inequality.
Other policies to reduce poverty and inequality
- Investment in human capital - Enhancing access to education and healthcare to improve skills and opportunities.
- Transfer payments - Providing benefits like pensions, unemployment support, disability allowances, and other welfare payments.
- Targeted spending - Funding public services such as health initiatives, school meal programmes, and infrastructure in deprived areas.
- Universal basic income (UBI) - Giving all citizens a regular payment, regardless of income or job status.
- Minimum wage policies - Setting a floor on earnings to boost incomes for low-skilled workers.