Taxation –

supplementary
notes
A2 Economics
Edexcel 4.3.5 part 2 and 4.5.4
Direct taxes

• Direct taxation
– Direct taxation is levied on income, wealth and profit while
indirect taxation is levied on expenditure
– Direct taxes include income tax, national insurance
contributions (UK), capital gains tax, and corporation tax
– You should be able to describe what has happened to
government receipts over time (amount/size, and the %
contributed by each type of tax) – refer to the previous there
pie charts
Indirect taxes

• Indirect taxation
– Indirect taxes is levied on spending on goods and services
– Indirect taxes include VAT; excise duties on fuel and alcohol,
car tax, betting tax and the TV licence
– VAT: An indirect tax at the rate of 17.5%, although domestic
fuel is taxed at 5%
– Excise duties are specific duties. The main duties are placed
on cigarettes, alcohol, and fuel
Evaluation: Direct versus Indirect
tax. The K is provided – you need
to provide the A and P
Case For Indirect Taxation
 Changes in indirect taxes are more
effective in changing the pattern of
demand for particular products
 Indirect taxes are a useful instrument
in controlling and correcting for
externality effects
 Indirect taxes are less likely to distort
the choice between work and leisure
and therefore undermine work
incentives
 Indirect taxes can be changed more
easily – providing the government
with increased flexibility
 Indirect taxes provide an incentive to
save (and avoid the tax)
Case Against Indirect Taxation
 Many indirect taxes have regressive
effects on certain consumers and
thus make the distribution of income
more unequal
 Raising indirect taxes can cause cost-
push inflation as producers pass on
higher taxes to retailers
 Revenue streams are uncertain
particularly when inflation is low or
there is an recession when consumer
demand falls
Evaluation: Direct versus Indirect
taxation

Case For Indirect Taxation (i.e. the case Case Against Indirect Taxation (i.e. the
against Direct Taxation) case for Direct Taxation)
Progressive taxation

• Progressive taxes
– With a progressive tax, the marginal rate of tax rises as income rises. I.e. as
people earn more income, the rate of tax on each extra pound/dollar earned goes up
– This causes a rise in the average percentage rate of tax

• Pros and cons of progressive taxes?

HK 2019-2021
https://www.pwchk.com/en/budget/2020/tax-facts-and-figures-en.pdf

Note that there are several “personal allowances” that

will reduce the amount of tax an individual has to pay.

How does the UK compare to Hong Kong?

 Marginal rates of tax

40
Marginal
rate
Tax rate (%)

20

10

O Basic tax Higher tax Additional tax threshold

Personal threshold threshold
allowance Individual’s pre-tax income (£)
 Marginal and average rates of tax –
progressive taxation

40
Marginal
rate
Tax rate (%)

22 Average Rate

10

O B H A

Individual’s pre-tax income (£)

Proportional taxation

• Also known as a flat tax

• The same % is taken from income, no matter what the
person earns

• Pros and cons of a flat tax?

Regressive taxation

• Regressive taxes
– With a regressive tax, the rate of tax falls as incomes rise
– In the UK, most examples of regressive taxes come from
duties on items of spending such as cigarettes and alcohol.

Pros and cons of regressive taxes?

Class discussion

• If 1% of tax earns $10m, it makes sense mathematically

that 2% of tax earns $20m, and so on.
• Does increasing the tax rate always increase tax
revenues?
• What about if the tax rate were 100%?
The Laffer Curve Idea
Total tax revenue

0 100

Average tax rate (%)

The Laffer Curve

• US economist Arthur Laffer

• Looks at the relationship (tradeoff) between tax rates
and tax revenue
• Says that as tax rates rise, tax revenues rise at first but
at a diminishing rate
• Concept that there might be a revenue maximising tax
rate – the peak of the Laffer Curve
• Raising taxes beyond this point could reduce tax yields
because it penalises work (output and employment)
The Laffer Curve Idea

R max.
Total tax revenue

0 t1 100

Average tax rate (%)

The Laffer Curve Idea

R max.
Total tax revenue

0 t1 100

Average tax rate (%)

The Laffer Curve Idea

R max.

R1
Total tax revenue

0 t1 t1 100

Average tax rate (%)

The Laffer Curve

• Often used as a justification for lower taxes as a supply

side policy to improve incentives
• Of contemporary relevance given the interest in flat-rate
taxes e.g. in Eastern Europe
The Laffer Curve – economic
reasoning for cutting taxes

Action: The government offers a lump-sum tax rebate or lowers the

basic / higher rates of tax
1.Post-tax rates of return to working increase – improved incentives to
work “at the margin”
2.Lower taxes may encourage inflows of FDI
3.Higher disposable incomes – boosts consumption
4.Less incentive to avoid / evade taxes
5.Lower company taxes increases planned investment and boosts
stock prices (reducing the cost of capital)
6.Lower taxes may lead to an improvement in the long run trend rate
of growth for the economy
Evaluation

• The central question is the elasticity of work with respect to tax

rates – will people work longer if taxes are cut?
– No guarantees!
– How many people have flexibility in the hours they work?
• Why should the government seek to maximise revenue from
taxation?
• Which is best – a lump sum tax rebate or a cut in tax rates?
• Lower taxation will, in the short term, increase the size of the
budget deficit, this will increase bond yields (interest rates) which
might have a negative effect on demand
• Really – the Laffer Curve is just an application of the idea of
diminishing returns
Factors affecting tax revenues

Level of Oil prices & other Changes in the

employment and costs – affect real incomes of
unemployment business profits people in work

Factors that influence total tax revenues

The tax base – how Asset prices – e.g. Rate of economic

many things the changes in share growth and the
government taxes and house prices rate of inflation
Key issues – Evaluation points on
tax

• The reasons for taxation

• Taxation and the redistribution of income and wealth
• Taxation and labour market incentives
• Taxation and the supply-side of the economy
Reasons for having taxation

• Meeting the benefit principle when financing the

provision of public services
• Changing the level and pattern of demand
– Macroeconomic demand management / macro stability
– Microeconomic effects of tax changes – influencing
consumer choices through the price mechanism
• Influencing the distribution of income and wealth –
using taxation to achieve a more equitable distribution of
final income
• Helping to correct for market failure e.g. environmental
taxation
The benefit principle of taxation

• The ‘benefit principle of taxation’states that people

who benefit from government spending should
contribute towards it by paying tax
• There are some problems with the benefit principle
– It ignores the redistributive aims of taxation. The benefit
principle is mainly concerned with allocative efficiency rather
than equity.
– The benefit principle assumes correct revelation of
preferences by consumers – whereas in reality many
consumers do not have to pay for the public goods and
services provided for them (free-riders)
Fiscal drag

• Government tax revenues can often rise without anyone really noticing!
• Fiscal drag happens when the value of items that are taxed rises more
quickly than the value of tax free allowances
– Income tax: Earnings from work rise faster than the annual upgrade in the
tax free allowance
– House prices: Tend to rise faster than the allowances for stamp duty and
inheritance tax
• When the economy is strong and real incomes and asset prices are rising,
“fiscal drag” can add several billion dollars/pounds a year of extra tax
revenue into the government’s coffers
• General definition
– The increase in real tax revenue when inflation raises nominal income and
pushes people into higher tax brackets in a progressive income tax system
Taxation and incentives

• How do changes in taxation affect individual incentives?

• Incentives:
– To spend money on specific goods and services
– To work or not to work (take leisure)
– To save e.g. for retirement
– To take risks e.g. self employment / entrepreneurship
Incentives (1)
Taxation and our spending
choices
• Using taxation to achieve environmental aims:
• Examples?
– Real increase in the cost of fuel duty
– Reducing car tax on pollution efficient vehicles
– Higher duties on cigarettes
– Higher taxes on alcohol and high fat foods?
• Problems:
– Equity issues
– Effectiveness issues
– Measurement issues
Incentives (2) Taxation and work
incentives in the labour market

• Other things being equal:

• If the government reduced the basic rate of income tax
from 22% to 20% would this cause a rise in the labour
supply?
• What economic concepts might be usefully applied?
• What is the reasoning that people would work more?
• Build a counter argument – why might people substitute
work for a greater amount of leisure time
Taxation and work incentives

Marginal Labour
Tax Rate Migration

Flexibility Leisure
Of Hours Hours
Income and substitution effects
• Income effects:
• Takes less time working to
achieve the same amount of
income
• Does leisure have a high
income elasticity of demand?
• Will some people cut back on
their hours having reached a
satisfactory target income?
• Substitution effects:
• The opportunity cost of
taking leisure time has risen
(why?)
• The post tax returns from
working have increased
• An incentive to work longer
hours?
• But are you always more
productive?
Taxation and the supply-side

• Consensus that tax systems can have an important

effect on the supply-side of an economy
– Income tax and the incentive to work
– Corporation tax
• Incentives to invest in new capital
• Tax competition as a means of attracting foreign direct
investment into a country
– Taxation and the incentive to spend on research and
development
– Employment taxes and the demand for labour