4.5.2a Types of taxes
Types of Taxes
Definition
Direct tax: a tax levied on income and wealth, such as income tax and National Insurance, paid directly to the government by the person or firm on whom it falls.
Indirect tax: a tax levied on spending, such as VAT and excise duties, collected by sellers and passed on to the government.
- The burden of a direct tax stays with the taxpayer, whereas the burden of an indirect tax can be shifted from seller to consumer through higher prices.
- A second way to classify taxes is by how the average rate changes with income, which is what determines their effect on inequality.
Progressive, Proportional and Regressive
Definition
Progressive tax: the average tax rate rises as income rises, for example UK income tax.
Proportional tax: the average tax rate stays constant whatever the income.
Regressive tax: the average tax rate falls as income rises, as many indirect taxes do.
- A progressive tax narrows the gap in post-tax income because higher earners give up a larger share of income, so it reduces inequality.
- But steep marginal rates can blunt incentives to work, save and invest, because each extra pound earned is taxed more heavily.
- VAT is regressive because a fixed rate takes a larger share of a low earner's income, who spends most of it, than of a high earner's, who saves more.
Average and Marginal Rates
Definition
Average tax rate: total tax paid divided by total income.
Marginal tax rate: the tax paid on the next pound earned.
- It is the average rate, not the marginal rate, that tells you whether a tax is progressive, proportional or regressive.
Example
A person earning £30,000 who pays £6,000 in tax has an average rate of:
ATR=600030000×100=20% \text{ATR} = \dfrac{6000}{30000} \times 100 = 20\% ATR=300006000×100=20%If income rises to £40,000 and tax to £9,000, the average rate rises to:
ATR=900040000×100=22.5% \text{ATR} = \dfrac{9000}{40000} \times 100 = 22.5\% ATR=400009000×100=22.5%The average rate has risen with income, so the tax is progressive.
In the UK, income tax is progressive through HMRC: a tax-free personal allowance is followed by rising marginal rates of 20%, 40% and 45%, so the average rate climbs with income, while the 20% standard rate of VAT is regressive.
Exam technique
- Classify a tax by tracking what happens to its average rate as income rises, not by how much revenue it raises.
- Keep the average rate and the marginal rate distinct when calculating.
Common Mistake
- Do not call any large tax progressive, since what matters is how the average rate changes with income.
- Do not confuse the average rate with the marginal rate, which applies only to extra income.
Self review
- Distinguish a direct tax from an indirect tax.
- Define a progressive, a proportional and a regressive tax.
- How do you calculate the average tax rate?
- Why is VAT regressive?
4.5.2b Economic effects of tax changes
Effects of Tax Changes
- Changes in direct and indirect tax rates affect incentives, tax revenue, income distribution, real output and employment, the price level, the trade balance and FDI flows.
Incentives to Work
- Cutting direct taxes such as income tax raises the reward from an extra hour worked, so the substitution effect can strengthen incentives to work, save and invest.
- But the income effect works the other way, and evidence suggests labour supply responds only weakly, so the net effect is often small.
Tax Revenue and the Laffer Curve
Definition
The Laffer curve: the relationship between the tax rate and total tax revenue, in which revenue first rises then falls as the rate increases, giving a single revenue-maximising rate.
- As the rate rises from zero, revenue first increases because each pound of an almost unchanged tax base is taxed more heavily.
- Beyond the revenue-maximising rate, higher rates weaken incentives and encourage avoidance and evasion, so the shrinking tax base outweighs the higher rate and revenue falls.
- Pictured as an inverted U, with the tax rate on the horizontal axis and tax revenue on the vertical axis, and the peak marking the revenue-maximising rate.
Income Distribution
- More progressive direct taxes reduce inequality by taking a larger share from higher earners and helping fund transfers to lower-income households.
- Heavier reliance on indirect taxes such as VAT tends to be regressive and can widen inequality.
Output, Employment and Prices
- Lower taxes raise disposable income and spending, increasing aggregate demand, real output and employment.
- Higher indirect taxes such as VAT raise firms' costs and prices, adding to the price level through cost-push pressure.
- Higher direct taxes reduce demand and can ease demand-pull inflation.
Trade Balance and FDI
- Lower taxes that boost domestic demand can raise imports and worsen the trade balance.
- Lower corporation tax raises after-tax returns and can attract foreign direct investment (FDI); Ireland's rate of 12.5%12.5\%12.5% has drawn large inflows.
- Higher business taxes can deter FDI and encourage firms to relocate abroad.
Example
- Ireland's low 12.5% rate of corporation tax has attracted heavy FDI from multinationals such as Apple, Google and Pfizer, illustrating how business taxes shape investment flows.
- The UK's 2013 cut in the top rate of income tax from 50% to 45% was defended partly on Laffer grounds, on the view that the 50% rate raised little extra revenue.
- The OECD's 15% global minimum corporate tax, agreed in 2021, aims to curb the race to the bottom in which countries cut rates to lure FDI.
Do higher taxes always raise more revenue?
- It holds up to a point because, at low rates, raising the rate collects more from a broadly unchanged tax base, so revenue rises.
- But beyond the revenue-maximising rate the Laffer logic bites: sharply higher rates blunt incentives and drive avoidance, so the base shrinks and revenue falls.
- The turning point is disputed and differs by tax and country, so where an economy actually sits on the curve is uncertain.
- On balance it depends on the starting rate, how mobile the tax base is and how strongly people respond to incentives.
Exam technique
- Trace a tax change through to a named variable such as output, prices or the trade balance.
- Use the Laffer curve to argue that very high rates can cut revenue.
Common Mistake
- Do not assume a tax cut always raises revenue, since it depends on where the economy sits on the Laffer curve.
- Do not treat incentive effects as certain, since responses are often small and disputed.
Self review
- How does cutting income tax affect incentives to work?
- What does the Laffer curve show about tax rates and revenue?
- How do tax changes affect income distribution?
- How can a tax change affect real output, employment and the price level?
- How can lower corporation tax affect FDI and the trade balance?
