Fiscal Policy: Types of Public Expenditure & Taxation (AQA A Level Economics)

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Written by: Lorraine

Reviewed by: Steve Vorster

Sources of Government Revenue

The main sources of government revenue include taxation, the sale of goods/services by government owned firms, and the sale of government owned assets (privatisation)

1. Taxation

Direct taxes are taxes imposed on income and profits
- They are paid directly to the government by the individual or firm
  - E.g. Income tax, corporation tax, capital gains tax, national insurance contributions, inheritance tax

Indirect taxes are imposed on spending
- The supplier is responsible for sending the payment to the government
  - Depending on the PED and PES producers are able to pass on a proportion of the indirect tax to the consumer
  - The less a consumer spends the less indirect tax they pay
  - E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods, excise duties on fuel etc.

2. Sale of goods and services

Government owned firms sometimes charge for the goods/services that they provide
- E.g. Charges on public transport and fees paid to access some medical services

3. The sale of government owned assets

Privatisation can generate significant government revenue during the year in which the government sells the asset
- Most assets can only be sold once e.g. national airlines or railways
- Some assets, such as the right for mobile phone operators to use the airwaves, can be sold every few years (the airway licence is for a defined period of time)

Types of Government Expenditure

Government expenditure represents a significant portion of the aggregate demand in many economies
The expenditure can be broken down into three categories:

Current expenditures: These include the daily payments required to run the government and public sector. E.g. The wages and salaries of public employees such as teachers, police, members of parliament, military personnel, judges, dentists etc. It also includes payments for goods/services such as medicines for government hospitals
Capital expenditures: These are investments in infrastructure and capital equipment. E.g. High speed rail projects; new hospitals and schools; new aircraft carriers
Transfer payments: These are payments made by the government for which no goods/services are exchanged. E.g. Unemployment benefits, disability payments, subsidies to producers and consumers etc. This type of government spending does not contribute to aggregate demand, as income is only transferred from one group of people to another

Why Governments Levy Taxes

Tax revenue is required to fund government expenditure

Diagram: reasons for government tax interventions

1-4-1-reasons-for-government-intervention_edexcel-al-economics

Taxes can be used to raise revenue, correct market failure, or generate more equity in society

Taxes can be used to discourage consumption
- Excise taxes (on alcohol, cigarettes) can be used to reduce the consumption of demerit goods that create negative externalities
- Tariffs (taxes on imports) can reduce imported goods
Taxes should aid the redistribution of income
- A good tax system should help the government redistribute income from the rich to the poor
- Revenue could also be used through the provision of services
  - Eg. Health care and education promote more opportunities for lower-income earners

Progressive, Proportional and Regressive Taxes

Tax systems can be classified as progressive, regressive or proportional
Most countries have a mix of progressive (direct taxation) & regressive (indirect taxation) taxes in place

An Explanation of Tax Systems

System	Explanation	Diagram
Progressive	As income rises, a larger percentage of income is paid in tax In the diagram, when personal income rises from Y₁ to Y2, the tax rate rises from TR₁ to TR₂
Regressive	As income rises, a smaller percentage of income is paid in tax In the diagram, when personal income rises from Y₁ to Y2, the tax rate falls from TR₁ to TR₂ All indirect taxes are regressive In the USA, Federal income tax is progressive but almost all State taxes are regressive (the bottom 20% of income earners pay as much as 6x the % of their income than the top 20%)
Proportional	As income rises, the same percentage of income is paid in tax In the diagram, when personal income rises from Y₁ to Y2, the tax rate remains constant at 20% In 2022, Bolivia was using this system with a proportional tax rate of 13%

Progressive tax systems are built around the idea of marginal tax rates
The calculation of an individual's personal income tax requires several calculations
Using this system, a salary of £60,000 would attract a tax bill of £11,499.80, calculated as follows:

Calculation Using UK Progressive Tax Rates - June 2022

Tax Band	Taxable Income	Tax Rate	Tax Paid on £60,000
Personal Allowance	Up to £12,500	0%	0
Basic Rate	£12,501 to £50,000	20%	£37, 499 at 20% = £7499.80
Higher Rate	£50,001 to £150,000	40%	£10,001 at 40% = £4,000
Additional Rate	Over £150,000	45%	0
Total Tax Paid on £60,000			£7499.80 + £4,000 = £11,499.80

The average tax rate measures the overall burden of the tax on the taxpayer

$The Average Tax Rate = \frac{Total tax paid}{income} \times 100 or \frac{T}{Y} \times 100$

The marginal tax rate is the tax paid on the last pound of income earned

$The Marginal Tax Rate = \frac{Change in total tax paid}{Change in income} \times 100 or \frac{∆ T}{∆ Y} \times 100$

Worked Example

Calculate the average tax rate for an individual who has an income of £38,000

Taxable income (£)	Income Tax Rate 2014/2015
from £0 to £5 000	0%
from £5 001 to £20 000	20%
from £20 001 to £40 000	40%
£40 001 and over	50%

Step 1: Calculate tax on each bracket

Individual pays tax: (5,000 x 0%) + (15,000 x 20%) + (18,000 x 40%)

Step 2: Sum each bracket

0 + £3,000 + £7,200 = £10,200

Step 3: Substitute values into the formula

$T h e A v e r a g e T a x R a t e = \frac{T o t a l t a x p a i d}{I n c o m e} \times 100 T h e A v e r a g e T a x R a t e = \frac{£ 10, 200}{£ 38, 000} x 100 T h e A v e r a g e T a x R a t e = 26.84 %$

The Principles of Taxation

In order for the population to accept a tax system and pay into it, the taxes imposed need to be considered to be 'good'
There are several principles which should be applied when developing a 'good' tax system

Simple: taxpayers should know what, when, where and how to pay the tax
Fair (equity): taxes should reflect a taxpayer’s ability to pay; progressive taxation aims to achieve this as the wealthy can afford to pay more than the poor do
Convenient: systems to collect payment should be easy and provide choice for taxpayers e.g. monthly payments spread over 12 months or tax collected by the employer each month before the salary is paid
Efficient: the management of the tax system by the government should not be overly expensive or wasteful
Fit for purpose: there should not be any unintended side effects of the system, e.g. disincentivising workers from working
Flexible: it should be easy to adjust/change as required by changes in the economy

The Role & Relative Merits of Different UK Taxes

The tax system of a country determines who pays the most
- In the UK, corporations pay less than households
- In Singapore, households pay less than corporations

Graph: source of UK revenue by taxation type 2017-2022

Stacked bar chart showing UK tax revenue by source from 2017 to 2022. Categories include income tax, NICs, VAT, corporation tax, and others.

Households have to pay VAT, Income tax, national insurance contributions (NICs)
Source: www.gov.uk

Role and Merit of Different UK Taxes

Direct taxes	Indirect taxes
In the UK, income tax is collected by the government through ‘pay as you earn’ (PAYE) Income tax is cheap to collect, convenient and certain for the taxpayer It is equitable as it reflects taxpayers’ ability to pay As tax rates rise, it increases the disincentive to pay tax which creates an incentive to reduce hours worked The marginal rates of tax should not discourage workers from working overtime It also lead to a brain drain as people leave the country in order to find countries with more generous tax systems It is debatable whether or not increasing top rate taxes on income raises extra revenue, or whether it may result in less money being collected	Value Added Tax (VAT) is levied on the sale of goods and services. It accounts for roughly 20% of tax revenue The costs of collection is placed on traders / retailers and not the state. The revenue collected is much greater than the costs of collection They are harder tax to evade as the tax is built into the selling price they are impossible to evade As they are included in the selling price, they are convenient for the taxpayer VAT does not take a person’s ability to pay into account and so the burden falls more heavily on lower income groups With rising prices it may be a disincentive to spend
Capital and wealth taxes are considered to be progressive taxes and have the potential to reduce inequality and generate a high level of government revenue It could discourage the accumulation of large levels of wealth However, it could act also as a disincentive to declare wealth/capital and tax avoidance / evasion may occur. There is a risk that they could also discourage the honest declaration of wealth and lead to tax avoidance or evasion	Excise duties are levied on demerit goods such as tobacco, alcohol, sugar They are always specific or unit taxes, levied on the physical quantity of the good This tax would bring in much needed revenue for the government that could help fund health initiatives It could be programmes which fund education on health impacts and act as a disincentive to consume these demerit goods May lead to hidden market economy activities leading to a loss of revenue for the state

Direct taxes

Indirect taxes

In the UK, income tax is collected by the government through ‘pay as you earn’ (PAYE)
- Income tax is cheap to collect, convenient and certain for the taxpayer
- It is equitable as it reflects taxpayers’ ability to pay
As tax rates rise, it increases the disincentive to pay tax which creates an incentive to reduce hours worked
- The marginal rates of tax should not discourage workers from working overtime
- It also lead to a brain drain as people leave the country in order to find countries with more generous tax systems
- It is debatable whether or not increasing top rate taxes on income raises extra revenue, or whether it may result in less money being collected

Value Added Tax (VAT) is levied on the sale of goods and services. It accounts for roughly 20% of tax revenue
- The costs of collection is placed on traders / retailers and not the state. The revenue collected is much greater than the costs of collection
- They are harder tax to evade as the tax is built into the selling price they are impossible to evade
- As they are included in the selling price, they are convenient for the taxpayer
- VAT does not take a person’s ability to pay into account and so the burden falls more heavily on lower income groups
- With rising prices it may be a disincentive to spend

Capital and wealth taxes are considered to be progressive taxes and have the potential to reduce inequality and generate a high level of government revenue
- It could discourage the accumulation of large levels of wealth
- However, it could act also as a disincentive to declare wealth/capital and tax avoidance / evasion may occur.
- There is a risk that they could also discourage the honest declaration of wealth and lead to tax avoidance or evasion

Excise duties are levied on demerit goods such as tobacco, alcohol, sugar
- They are always specific or unit taxes, levied on the physical quantity of the good
- This tax would bring in much needed revenue for the government that could help fund health initiatives
- It could be programmes which fund education on health impacts and act as a disincentive to consume these demerit goods
- May lead to hidden market economy activities leading to a loss of revenue for the state

Last updated: 15 October 2024

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