Taxation (Cambridge (CIE) O Level Economics)

Revision Note

Written by: Steve Vorster

Reviewed by: Jenna Quinn

The Classification of Taxes

The main source of government revenue is 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 less a consumer spends the less indirect tax they pay
- Examples of indirect tax include Value Added Tax (19% VAT rate in the European Union in 2022), taxes on demerit goods, excise duties on fuel etc.

Progressive, regressive and proportional tax systems

Tax systems can be classified as progressive, regressive or proportional
Most countries have a mix of progressive (direct taxation) and 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

Examiner Tips and Tricks

MCQ frequently test your knowledge of the different tax systems by presenting you with a table and asking you to identify the type of tax system illustrated

Identify the type of tax system illustrated below:

Weekly Income ($)	100	150	200	250
Weekly Tax ($)	20	30	40	50

It is a proportional tax system with a constant tax rate of 20%

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 Impact of Taxation

Changes in direct and indirect tax rates influence a range of economic variables
- The greater the size of the change, the greater the ripple effects felt by households, firms and the economy

Effects of Tax Rate Changes

Impact	Explanation
Incentive to work	The higher the tax rate, the lower the incentive for the unemployed to seek work - or for existing workers to work overtime
Government tax revenues	There is a relationship between increasing tax rates and the level of government revenues received The broad idea is that as tax rates increase, a point will be reached where disincentivized workers work less, resulting in lower incomes and less government tax revenue More people will actively seek to avoid paying tax (tax avoidance) or try to move their income elsewhere
Income distribution	A progressive tax system redistributes from those with higher income to those with lower income and reduces income inequality Sometimes the benefits of a good progressive tax system are lost by the penalties imposed through multiple regressive (indirect) taxes
Economic growth	Tax rate increases will likely cause a reduction of total (aggregate) demand as firms and households have less disposable income Tax rate decreases will have the opposite effect As total demand slows down, fewer workers may be required for production and unemployment may increase
Inflation	Increasing Indirect tax rates increase costs of production for firms possibly leading to cost-push inflation An increase in indirect taxes reduces disposable income and so workers may petition their employer for a salary increase If they receive the increase the economy may face a wage-price spiral
The trade balance (X-M)	An increase in taxes can reduce disposable income which is likely to reduce the level of imports This may improve the trade balance (exports - imports)
Business location	If the rate of corporation tax increases relative to other countries, it may result in less inward foreign direct investment by multi-national corporations

Last updated: 18 June 2024

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