Some Key Tax Issues
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Some Key Tax Issues
Generally, direct taxes are progressive and indirect taxes are regressive. Because of the effect of zero rated goods, it can be argued that VAT is broadly proportional.
The changes during the 80s that moved the system away from direct taxation and towards indirect taxation certainly made the system more regressive, but it was already very progressive at the start of the 80s. The changes balanced things out.
The Labour government have made a few changes that have helped poorer households. They brought in a new low starting rate of income tax (10%) and the Working Families Tax Credit.
Overall, the tax system is now broadly proportional. Some would argue that developed countries should have progressive systems so that the richer members of society are helping those who are less fortunate. There, are problems, though, with incentives. There is no point raising the taxes of the better off if they then simply try to avoid them (legally) or move abroad.
Over the last twenty years, the tax system in the UK has moved from being one where the majority of taxes were direct in nature to one where the majority are now indirect in nature.
The marginal rate of income tax on top earners has fallen from 83% in 1979 to 60% up until the 1987 Budget, where it was reduced to 40%. The basic rate fell from 33% in 1979 to 25% in the 1987 Budget and is now only 22%. There is now also a lower starting rate of 10%.
Meanwhile, indirect taxes have risen. VAT was only levied at 8% in 1979. This was raised to 15% in the first Budget of the Conservative government, and then to 17.5% in 1991. The tax was also extended to domestic fuel, previously zero-rated. Duties on fuel, tobacco and alcohol are very regressive and have tended to rise at a rate higher than the inflation rate.
Has this been a good or a bad thing for the economy? Here are some of the issues to consider.
As explained in the first Learn-It of this topic, direct taxes are broadly progressive and indirect taxes are broadly regressive. The move from direct to indirect has made the distribution of income in the UK less equal. Whether this is right or not is a normative economic question.
Many economists do not like the idea of direct taxes (and income tax in particular) being too high. They argue that it acts as a disincentive to work, which may result in a reduction in the quantity and quality of the workforce.
But high indirect taxes raise the price of goods and services consumed and so reduce a worker's real income, just as a rise in income tax rate would (although in not such an obvious way). The extent to which this happens depends on the elasticity of demand for the good that is being taxed. This is the problem with petrol, tobacco and alcohol. All have inelastic demand, so the increase in the indirect tax can be passed on almost entirely by the producer on to the consumer.
So, again, the argument is balanced. It can be argued, though, that increases in direct taxes are far more visible and may affect the quantity and quality of labour more directly. See 'The Laffer curve' below for more discussion on incentives.
When income tax rates are high, workers are left with less of their original income that they, themselves, can choose how to spend. If income tax rates are very low and taxes on goods and services are high to compensate, at least the worker will have more money to decide what to buy. He can organise his purchases so that he avoids paying tax by buying the goods that have a lower indirect tax levied than others. Of course, with a tax system that has low direct taxes and high indirect taxes, it would be fairly hard to avoid buying a good that did not have a fairly hefty tax levied on it!
One of the big advantages of indirect taxation is that the government can use it to force the market to allow for externalities. A free market will tend to over produce a good and sell it at too low a price when a negative externality is involved. The external cost of production is not part of the firm's private costs. If an indirect tax is imposed on these goods then the government will be increasing the firm's costs and forcing it to produce less at a higher price. Hopefully the socially optimal level of output will be produced. This is one of the reasons why alcohol and tobacco is taxed so heavily. Both products create huge external costs to society in the form of an increased bill for the NHS. For much more detail, see the topic called 'Market failure'.
The administrative cost of indirect taxes tends to be lower. Income tax is levied on all individual workers. The retailer, for example, pays VAT, so the billing procedure is much simpler. This is definitely a more minor point, especially given that advances in computer technology make all methods of collection relatively cheap.
Indirect taxes can be changed more easily. Direct taxes can only be changed on Budget day whereas indirect taxes can be changed at any time. It is also much harder to avoid paying an indirect tax. There are lots of legal ways of avoiding paying income tax as long as you have a good accountant! One further bad point, though. The imposition of indirect taxes tends to force the price of goods and services up, which is inflationary.
If you asked most taxpayers in this country, I'm sure the answer would be yes! Actually, we are about mid table in the world league table. In the tax year April 1999 to April 2000, the tax burden in the UK was 37% (Total taxes and social security contributions as a percentage of GNP). Many European countries have higher tax burdens. Sweden and Denmark have burdens of over 50%. Countries like the USA and Japan have rates below 30%, though. It should be noted that the UK takes less of their tax in the form of direct taxes. The top rate of income tax in this country, 40%, is one of the lowest in the world.
We mentioned earlier that some economists feel that high marginal income tax rates can act as a disincentive to work. The diagram below illustrates this to a certain extent.
The diagram shows the relationship between the marginal tax rate and the total tax revenue that the government will receive. If the tax rate is zero, then obviously the government would collect no revenue. Also if the tax rate is 100% then one assumes that the government will receive no tax because no one would work with such a penal tax system! The question is, at what rate of tax would the government maximise its intake of tax revenue? It has been estimated that this peak would occur at around 60% in the UK. This rate takes all taxes into account and expresses than as a percentage of GDP.
It is interesting to note that the current tax rate in this country (in terms of the tax burden) is only 37%, which is well below the 60% figure. Whilst further studies have shown that there is a disincentive to work as the tax rate approaches 60%, regardless of the increase in tax revenue, there certainly is no support for a tax rate below 40%.
The discussion about the lack of incentives so far has focused on average to high earners being put off by higher marginal tax rates. There is, some would say, a graver problem associated with incentives at the other end of the spectrum.
A poverty trap is where a worker in a low paid job has no incentive to pull himself out of poverty with a higher paid job because of the resulting loss in benefits (like Housing benefit and Family credit) and increased tax payments. The resulting effective marginal tax rates can be much higher than anything a richer member of society has to pay.
If you are in a low paid job supporting a family (say, £100 a week), then a pay rise (to, say, £150 a week) may not result in an increase in disposable income at all! The resulting loss in benefits coupled with the slight increase in the income tax and NICs that need to be made means that the effective marginal tax rate can be as high as 90%, or even 100%. It is possible that the effective marginal tax rate is more than 100%! When earning £100 a week, this worker's disposable income with benefits may be, say, £200. But when he is earning £150 a week, the loss of benefits and increase in tax payments may mean that his disposable income is only, say £195 a week.
The unemployment trap is exactly the same, except that the worker has no incentive to actually find a job from a position of unemployment for the same reasons (loss of various benefits). Economists often talk about the replacement ratio.
If our previous worker on a disposable income of £200 a week lost his job, he would still receive various benefits to the tune of, say, £180 a week. The replacement ratio in this example is 90%. The benefits received when unemployed 'replace' 90% of the worker's disposable income when in work. In the 80s, replacement ratios were often over 100%! The introduction of the Family credit benefit in place of Income support in 1988 has helped this situation, but the replacement ratios are still very high.
The main problem here is that taxes are set by one government department (the Treasury) and benefits are set by another (Social Security). These systems really ought to be merged so that the tax and benefit system is one, but this is an extremely complicated task.
The Labour government introduced the Working Families Tax credit in 1999. This is a benefit for working households with children. Although it is basically a benefit, it is paid through a workers wage packet, the idea being that extra work is always rewarded. It will be interesting to see whether this new benefit will go some way towards eliminating the poverty and unemployment traps.