Some Basic Principles of Taxation

Some Basic Principles of Taxation

Fiscal policy refers to any policy of the government that involves taxation or government spending. In this and the next two Learn-Its, we look at taxation. In the final two Learn-Its of this topic we look at government spending.

  1. Raising money for government spending. The most obvious reason is to raise money for all the expenditure that is required. Hospitals, schools, the defence system, the welfare state; these things do not come cheaply. You will soon see that not all taxes are imposed centrally (by the Westminster Parliament). Local taxes also have to be levied to help pay for libraries, cleaning the roads, local parks and the local council administration to name just a few items. See the Learn-It called 'Government spending in the UK' for more detail.
  2. Redistributing income. This is a bit of an old fashioned objective of taxation nowadays. If the system used is progressive (see later in this Learn-It), then the tax system will be helping the relatively less well off at the expense of the better off. Socialist governments of the past were very keen on this. Certainly the Conservative governments of the 80s and 90s were less bothered. Although there is a lot of press about the increase in the tax burden under the new Labour government, they have actually been redistributing income to the poorer households in the UK, through such measures as the National Minimum Wage, the New Deal and the Working Families Tax Credit.
  3. Demand management. In the topic called 'Aggregate demand and aggregate supply', the Keynesian economists policy of demand management was outlined. Basically, Keynesians believe that in times of recession or depression, the markets will not 'clear', or sort themselves out at the right price, so it is the government's responsibility to create the necessary demand to resurrect the economy. This can be done by increasing government spending and/or reducing taxes.
  4. Correcting market failure. In the topic called 'Market failure', there is much discussion about the problems of externalities, like pollution from congestion. The markets, left to themselves, will not produce the socially optimal level of output. Governments can use taxes to force the firms to produce the socially optimal level of output. We all know about the tax on petrol. Some items that are thought of as 'good' may be exempt from taxes that most other goods attract. A few goods are 'zero-rated', meaning they attract no Value Added Tax (VAT). Books are a good example.

The only reason that a parliament was first formed in the thirteenth century was because the King at the time was short of money. He convened a meeting of some of the Lords of the time so that he could get some money from them. They, in turn, raised money from the peasants in their 'manor'. And so tax was invented. By the time that the first book was written (in 1776) that dealt with economic issues, "The Wealth of Nations" by Adam Smith, taxation was already quite a big part of peoples' lives. Smith discusses the 'cannons' of taxation. These were characteristics that all good taxes should have:

  1. Fairness. A tax should always consider the taxpayers' 'ability to pay'.
  2. Cost. The cost of collection (for the government) should not be too high. In particular, the cost should be a relatively small proportion of the tax yield.
  3. Convenience. It should be as easy as possible for the taxpayer to pay the tax (in terms of means and timing of payment). Note that the Pay As You Earn (PAYE) method of tax collection on most peoples' income is very good here.
  4. Certainty. The timing, method and amount due should be absolutely clear. There should be no excuses for tax evaders.

There is a good recent example of a 'bad' tax in terms of the four 'cannons' above. The Community Charge (or poll tax, as everyone called it) was introduced towards the end of Thatcher's reign and was abolished by Major as soon as he could after he took over in 1990. Although there were concessions for pensioners and the unemployed, this local government tax, which replaced the old property based tax, was a tax on each person within a household. Whether you earned £100,000 a year or £10,000 a year, the tax was the same flat amount. It was, therefore, very regressive (see later in this Learn It).

In terms of the cannons above, it was certainly not based on the ability to pay. It was also an unusually expensive tax to collect (4% of its yield; most taxes are half that cost). This was mainly because people move, whereas property cannot. In terms of convenience and certainty, it was not that difficult to understand the timing and the method, but it certainly wasn't as easy as the PAYE system used for income tax that most people understood.

There are lots of ways in which taxes can be categorised. Who collects the tax? The Inland Revenue or Customs and Excise (there are some taxes that neither of these bodies collect)? What is being taxed? Income, capital or expenditure (again, there are some taxes that do not fit into any of these three categories)? Most textbooks and economists like to start by categorising taxes into direct and indirect taxes.

A direct tax is one that is paid directly by the individual worker or firm. Income tax is the best example, usually being paid directly through PAYE. Firms pay corporation tax on their profits, which is a bit like an income tax for business. Others include Capital Gains tax, Inheritance tax, Stamp duty (paid when buying a house) and Petroleum tax (paid on North Sea Oil revenues).

Technically, National Insurance contributions are a direct tax, but the Inland Revenue as with all the other direct taxes does not collect them. Officially, they are called 'Social Security receipts', probably because they are payments towards the state pension and other benefits that one might require in times of need.

An indirect tax is one that is only paid indirectly through a third party. Consumers pay Value Added Tax (VAT), for example, but only if they actually buy the good or service in question. The retailer officially pays the tax, although it is likely that the price is raised to reflect the tax, so, effectively, the consumer ends up paying. Others include tobacco and alcohol duties, fuel duties (on petrol) and betting duties.

These terms are important when assessing whether a tax is fair or unfair. They are important concepts to understand as they relate to whether or not a tax is redistributive or not.

Progressive taxes

A progressive tax is one where, as one's income rises, one pays more tax as a percentage of one's income. The percentage part is important. Obviously higher income earners pay more tax than those on low incomes, but, is it more as a percentage of their income?

Income tax is the best example of a progressive tax. In the UK, an unmarried earner has an allowance - he does not pay any income tax on the first £4,500. He then pays 10% on the next £1,500, 22% on the next £27,000 and then 40% (the top marginal rate of income tax) on the rest. All these figures are to the nearest 500 and are per annum earnings. These rates are all marginal, though. As you can see, he will not even start to pay 40% on any additional £1 until he earns £33,000 a year. The point is that someone on, say, £40,000 a year will pay more tax than someone on £20,000, but not only will he pay more actual tax, but he will pay more as a percentage of his income.

Figures from the Office for National Statistics (ONS) suggest that direct taxes as a whole are progressive.

Regressive taxes

A regressive tax is one where, as one's income rises, the amount that is paid as a percentage of one's income falls. Notice, though, that a higher earner may be paying more of the tax in absolute terms, but as a percentage of their income, the amount is falling. These taxes are, obviously, considered to be unfair as they redistribute money from the poor to the rich (in relative terms).

The poll tax (the example used above) was very regressive. As stated above, whether one earned £50,000 a year or £10,000 a year, the amount paid (in a given local borough) was the same. A £500 tax bill, therefore, constituted only 1% of the high earner's salary, but 5% of the lower earner's salary. This is regressive and most people seemed to think this was unfair. The tax disappeared with its inventor, Margaret Thatcher.

Most indirect taxes are regressive. Let's take the example of fuel duty (the tax on a litre of petrol). A rich person might have a big expensive car that only does 20 miles per gallon. A poorer person might have a standard saloon that does 40 miles per gallon. They both drive to work and do the same sort of mileage each week. The richer person earns £100,000 a year and the poorer person earns £10,000 a year. The richer person will have to buy twice as much petrol because his car is twice as thirsty. Both drivers pay the same amount of fuel duty on each litre of petrol purchased, so the richer person pays twice as much fuel duty. But he earns 10 times as much money. Even allowing for the more progressive income taxes that the richer person has to pay, the tax he pays on his petrol as a percentage of his income is smaller than for the poorer person.

Proportional taxes

A proportional tax is one where, as one's income rises, one pays more tax, but the amount that is paid as percentage of one's income remains unchanged.

If there were no allowances in the tax system, and there was only one income tax rate of, say, 30%, then higher earners would pay more tax than low earners, but the amount they pay expressed as a percentage of their income would always remain the same (i.e. 30%). Someone earning £50,000 a year would pay £15,000 income tax, and someone on £10,000 a year would pay £3,000 tax. The high earner is paying much more tax, but in both cases, the amount paid is exactly 30% of one's income.

Some economists argue that VAT is a broadly proportional tax. As one gets richer, one will spend more money, but, in terms of, say, a trip to Tesco, there is only so much one can buy. A family of four trying to survive on £10,000 a year may struggle to keep their weekly shopping bill down to £100. A couple with no children earning £50,000 a year are unlikely to spend £500 every week at Tesco. In other words, as one's income rises, one's marginal propensity to consume falls (see the topic called 'Aggregate demand and aggregate supply' for details).

So in this sense the tax is regressive, because as one gets richer, one buys less as a percentage of one's income, and so one pays less VAT as a percentage of one's income. But, to compensate for this, many necessity goods, like babies clothes and basic foodstuffs, are 'zero-rated' meaning VAT is not levied on them. The family on £10,000 a year are more likely to be buying these types of goods. Certainly they will form a larger proportion of their shopping basket. This is the more progressive element of VAT.

Taking these two factors together, you can see why many economists think that VAT is a broadly proportional tax. Figures from the Office for National Statistics (ONS) for the tax year 1996-7 show that this is the case for middle earners, although those in the bottom fifth of households in the country (according to household income) do spend a larger proportion of their disposable income on VAT than those in the top fifth of households. The figures for the percentage of disposable income paid in VAT by the five quintile groups, starting with the poorest were 13.9%, 9.5%, 9.1%, 9.5% and 6.5%.