direct v indirect taxation
There has been a gradual shift away from direct towards indirect taxes in the UK over recent years. What are the potential demand and supply-side economic effects of this? What are the advantages of indirect over direct taxes?
Economic Incentives
Incentives in the labour market
Increased indirect taxation has allowed the government to reduce the overall tax burden on income and capital. Both income tax and corporation tax rates have been lowered.
Supply-side economists believe that indirect taxes are
preferable to direct taxes because they create less of a
If this is true, then the long-run output potential of the economy should rise through an expansion of aggregate supply would expand, generating a downward pressure on the general price level.
Income and substitution effects from a tax change
Will lower income tax rates cause people to work more hours? There are two effects from a tax change - the substitution and the income effect.
-
Substitution effect - when income tax rates are cut the return to working extra hours rises. This means the opportunity cost of leisure time is higher than before.
-
Income effect - when tax rate are reduced, people can earn a particular "target" post-tax income with fewer working hours than before the tax cut. If they regard leisure as a normal good, they may prefer to switch out of work and enjoy more leisure time whilst still earning the same income!
Which
effect is stronger when income tax rates are lowered?
For
the majority of tax payers the results of research are ambiguous.
One
group where increased indirect taxation and reduced direct taxation might
Lower starting rates of income tax may provide a better incentive for low-paid workers to enter the active labour market. The Labour Party has brought in a 10% starting rate of tax and has also introduced the working families tax credit as part of a strategy to boost the post-tax incomes of families in poorly paid jobs.
The incentive to save and invest
Direct taxes may create disincentives to postpone consumption through saving and also for firms to invest in new capital inputs. Interest on savings accounts is taxed at source (there is a new 10% rate of tax for low income earners with savings).
Indirect taxes on the other hand would appear to encourage saving - one of the ways to avoid high levels of excise duties is to reduce consumption.
Indirect Taxes and the Environment
One advantage of indirect taxes is that they can be used explicitly to correct for market failure caused by environment damage. Indeed governments across the world are coming to the view that indirect taxes can be used more intensively to meet environmental objectives.
Externalities
occur when the social costs of production or consumption exceed the private
costs, implying that the price does not reflect the true costs of production
and will result in over consumption of the good or service.
The
use of indirect taxation is one solution to the problem of externality: the
producer or consumer is charged the full social cost and demand will respond
accordingly. Environmental economists argue that the most effective way to
protect the environment from carbon dioxide and other energy-linked pollutants
is to tax the polluter.
Indirect tax increases will push up prices, decrease consumption and hence reduce the effects of negative externalities such as damage to the environment. However, there is a danger that using green taxation to influence demand will damage specific industries. For example, the high rate of taxation on alcohol sold in the UK, as opposed to continental Europe, has badly affected our drinks industry. A huge trade in importing alcohol has grown up, resulting in many jobs being lost in the UK.
The introduction of the Climate Change Levy has also sparked controversy with energy-intensive industries complaining that they will be badly affected by the new charge. There is clearly a potential conflict between efficiency and competitiveness with the desire to control pollution conflicting with the need for domestic producers to remain competitive in international markets.
Costs of Collection and Economic Flexibility
Taxes on spending are cheaper to administer than direct taxes because they are only collected from businesses
Indirect taxation gives the government more control over its use of fiscal policy. In theory, certain indirect taxes can be changed between budgets without parliamentary approval (e.g. VAT by up to 25%, excise duty by up to 10%). In contrast, direct taxes can only be changed in the annual budget.
The Distribution of Income
An important argument against indirect taxes is that they tend to be regressive. Since each individual pays the same rate on their purchases, the poor pay a larger proportion of their incomes in indirect taxes (in comparison with direct taxes which tend to be progressive and are seen as more equitable – the proportion of income paid in taxes rises as income rises when a tax is progressive). An example of this in the UK is the high level of duty on tobacco products. Evidence from the Office of National Statistics shows that the duty on tobacco takes up a much larger percentage of the disposable incomes of lower income groups.
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