Taxation

Funding public expenditure (like building roads or hospitals) is one of the reasons why governments collect taxes. The government uses the collected revenue to achieve certain economic goals including manipulating aggregate demand levels. A government also uses taxation for the redistribution of income in an attempt to lower income inequality and create a more equitable society.

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What is taxation?

Taxation is a system where individuals and businesses pay money to the government to fund its operations and services. The financial fuel keeps public infrastructure running, from schools and hospitals to roads and defense systems.

Taxation Definition

Classification of Taxes

Taxes can be classified or categorized based on various factors such as the method of collection, the impact on income distribution, or the type of goods or income they apply to. Here are some of the most common ways to classify taxes:

Direct and Indirect Taxes

Direct taxes are levied on individuals or organizations and must be paid directly to the government. They include income tax, wealth tax, corporate tax, etc. Indirect taxes are levied on goods and services and are collected by an intermediary from the person who bears the ultimate economic burden of the tax. Examples include sales tax, VAT, and excise tax.

Progressive, Regressive, and Proportional Taxes

A progressive tax increases as the taxable amount increases, meaning those with higher incomes pay a higher percentage of their income in tax. In contrast, a regressive tax takes a larger percentage of income from low-income earners than from high-income earners. A proportional tax, also known as a flat tax, levies the same percentage rate of taxation on everyone, regardless of income.

Ad Valorem and Specific Taxes

Ad valorem taxes are levied based on the value of the goods or property. Examples include property taxes or sales taxes. Specific taxes are levied based on quantity, such as excise taxes on fuel or cigarettes.

Consumption and Income Taxes

Consumption taxes are levied on the consumption of goods and services and include sales taxes and VAT. Income taxes are levied on the income of individuals and businesses.

Corporate and Personal Taxes

Corporate taxes are levied on the profits of businesses, while personal taxes are levied on individuals' income.

Taxation examples from different countries

Navigating the world of taxation can be complex, as each country employs its own unique system to collect revenue and fund public services. From progressive to regressive taxes, and from consumption to income taxes, the landscape of tax systems varies widely. In this section, we'll journey across the globe, exploring the taxation systems of three diverse countries: the United Kingdom, Sweden, and the United Arab Emirates. Each example shows how different nations balance the need for revenue generation with economic growth and societal welfare.

United Kingdom Taxation System

In the United Kingdom, a progressive income tax system is employed, where individuals pay a progressively higher rate of tax as their income increases. For the tax year 2021-2022, the rates range from 0% (for income up to £12,570 known as the personal allowance) to 45% (for income over £150,000). The UK also imposes a standard 20% Value-Added Tax (VAT) on most goods and services, with reduced rates for certain items and exemptions for others. In addition to these, the UK levies corporate taxes, council taxes, and inheritance taxes among others.¹

France Taxation System

France also operates a progressive tax system similar to the UK. Income tax rates range from 0% to 45%, depending on income levels. France also imposes a corporate tax rate, currently ranging from 15% to 31%, depending on the company's revenue. In addition, a Value Added Tax (VAT) is imposed on most goods and services, the standard rate being 20%. France's tax system is overseen by the Public Finances General Directorate (DGFiP).³

United Arab Emirates Taxation System

In contrast to the previous examples, the United Arab Emirates has a minimal direct taxation system. There is no federal income tax on individuals, and corporate taxes are largely limited to foreign banks and oil companies. The UAE introduced a value-added tax (VAT) of 5% in 2018, a relatively low rate on a global scale. This tax is levied on most goods and services, with some exceptions.²

Figure 1 shows that a large percentage of people's income is paid in taxes. Income tax is one of the main sources of government revenue in the UK, making up almost half of the public sector receipts in the year 2021/2022. This is a form of direct taxation.

Taxes on spending such as the VAT and fuel duty also make up a large percentage (18.3%) of government revenue, but it is significantly smaller than the tax revenue earned on income. These are both examples of indirect taxes.

Fig. 1 - Expected public sector revenue 2021–22. Source: obr.uk

Calculation of tax rates

To identify whether a tax is progressive, regressive, or proportional, we can take a look at the relationship between the average and marginal tax rates.

The formula for calculating the average tax rate is the following:

\(\text{Average Tax Rate}=\frac{\text{Tax Paid}}{\text{Income}}\)

Marginal tax rate

The marginal tax rate is the rate of tax you pay on an additional unit or an additional £1 of income. The formula for calculating the marginal tax rate is:

\(\text{Marginal Tax Rate}=\frac{\text{Change in Tax Paid}}{\text{Change in Income}}\text{ or }\frac{\Delta T}{\Delta Y}\)

In progressive systems, the average tax rate is lower than the marginal rate. In regressive tax systems, the average tax rate is higher than the marginal rate. This is because the proportion of income paid in taxes (average rate) decreases as income increases. In the case of a proportional tax system, both the average and marginal rates are equal.

The relationship between tax systems and tax rates

By calculating the average tax rate we can see the overall burden of the tax on the taxpayer, whereas the marginal rate can be used as an indicator for decision making.

The marginal tax rate is a significant factor when it comes to making decisions about work and leisure, which influences the supply of labour. Suppose the marginal tax rate increases significantly, leading to a highly progressive tax system. In that case, people (especially high-income earners) will choose to work less as being taxed more heavily disincentivises them from working more. This decreases the supply of labour in the economy.

Additionally, high marginal tax rates also reduce saving, which has a negative impact on investment in the economy. A lower supply of labour and investment can result in reduced growth rates in the economy.

Principles of taxation

Adam Smith's principles of taxation, also known as canons of taxation, argue that taxes should be:

1. Equitable: the tax system should be fair based on everyone’s ability to pay.

2. Economical: the tax should be cheap to collect.

3. Convenient: the tax should be convenient for taxpayers to pay.

4. Certain: the taxpayer should be certain of the amount of tax they are due to pay.

Furthermore, we could add the principles of efficiency and flexibility. The idea of efficiency suggests that the tax should achieve its desired objectives and flexibility implies that the tax should be relatively easy to change in case new circumstances arise.

According to Adam Smith's principles of taxation, a relatively well-designed tax should meet many of the principles outlined above, whereas a relatively badly designed tax meets only a few of the principles.