Definition
Direct tax: a tax levied on the income or wealth of individuals and firms, such as income tax, where the burden cannot be passed on to anyone else.
Indirect tax: a tax levied on spending and collected through the seller, such as VAT, where the burden can be passed on to the consumer.
Direct and indirect taxes
- Income tax, corporation tax and inheritance tax are direct taxes charged on what people earn or own.
- VAT and excise duties on fuel, alcohol and tobacco are indirect taxes charged when money is spent.
- The incidence of an indirect tax can be shifted from seller to consumer via a higher price, so the legal payer and the effective payer differ. Refer to 3.2.1 to review the incidence of tax on consumer or producer.
Average and marginal rates
Average rate of tax (art): the proportion of total income paid in tax.
art=total taxtotal income×100% \text{art} = \dfrac{\text{total tax}}{\text{total income}} \times 100\% art=total incometotal tax×100%Marginal rate of tax (mrt): the proportion of an extra slice of income paid in tax.
mrt=ΔtaxΔincome×100% \text{mrt} = \dfrac{\Delta \text{tax}}{\Delta \text{income}} \times 100\% mrt=ΔincomeΔtax×100%Key Idea
- When mrt > art, each extra pound is taxed more heavily than income already earned, so the art is pulled upward as income rises.
- This rising average rate is exactly what makes a tax progressive.
Example
- A worker earns £20000 and pays £2000 in tax.
- So 10% of income is taken at this level of income.
- Income then rises by £10000 to £30000 while tax rises by £2000 to £4000.
- The average rate climbs from 10% to 13.3% because mrt (20%) exceeds art, confirming a progressive tax.
Progressive, regressive, proportional
Definition
Progressive tax: a tax that takes a rising share of income as income rises, so the art increases.
Proportional tax: a tax that takes a constant share of income, so the art stays the same.
Regressive tax: a tax that takes a falling share of income as income rises, so the art decreases.
Example
- A fixed £300 sales tax is paid on a good by a consumer earning £10000 and by one earning £30000.
- The share of income falls from 3% to 1% as income rises, so this indirect tax is regressive.
Example
- Income tax is 20% on income above a £12500 tax-free allowance, and a worker earns £20000.
- The government raises the allowance to £15000 while leaving the rate unchanged.
- The allowance makes income tax progressive, and raising it cuts the worker's average rate from 7.5% to 5%, so disposable income and consumption rise.
Reasons for taxation
- To raise revenue to fund public services such as healthcare, education and defence.
- To redistribute income, using progressive taxes and transfer payments to reduce inequality.
- To correct market failure by taxing demerit goods and negative externalities so price better reflects social cost.
- To manage aggregate demand, since raising or cutting taxes changes disposable income and spending.
Are higher, more progressive taxes the best way to raise revenue?
- Progressive direct taxes such as income tax score well on equity and revenue: they take a rising share of income from those best able to pay, help redistribute income, and provide a relatively stable, hard-to-avoid revenue base for public services.
- However, high marginal rates can weaken the incentive to work, save and invest, and may encourage avoidance, evasion or the emigration of high earners. If rates are pushed high enough, these responses can shrink the taxable base so much that a higher mrt collects less revenue rather than more.
- Indirect taxes are harder to avoid and can discourage demerit goods, but a flat duty on necessities tends to be regressive, so leaning too heavily on them can worsen inequality.
- On balance, the best tax mix depends on the government's priority between equity and efficiency, how responsive workers and firms are to tax rates, the ease of collection and avoidance, and how high existing rates already are.
Exam technique
- Decide the label by asking whether the average rate rises, stays constant or falls as income rises.
- Always show the fraction and the % result rather than asserting the answer.
- Judge fairness by the share of income taken, not by the cash sum paid.
Common Mistake
- Do not judge progressivity from the cash amount of tax paid.
- A larger cash sum can still be a smaller share of a larger income.
- Do not assume every indirect tax must be regressive.
- It depends on the good, since a duty on luxuries bought mainly by the rich can be progressive while a flat duty on necessities is regressive.
Self review
- Distinguish a direct tax from an indirect tax and give one example of each.
- State the formulae for the average and marginal rates of tax.
- A worker pays £3000 on £20000, then £6500 on £30000; find the mrt and state the tax type.
- Explain why a fixed sales tax is usually regressive.
- Give two reasons why governments levy taxes.
