Study notes

Fiscal Policy - Analysing Direct and Indirect Taxes

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB, Other, Pre-U

This study note looks at the relative advantages and disadvantages of direct and indirect taxation

Direct taxes

Direct taxes are paid directly to the government by the individual taxpayer – usually through “pay as you earn”. The tax liability cannot be passed onto someone else

Indirect taxes

Indirect taxes – include VAT and excise duties. The supplier can pass on the burden of an indirect tax to the final consumer – depending on the price elasticity of demand and supply for the product.

Arguments For Using Indirect Taxation

Arguments Against Using Indirect Taxation
  • Changes in indirect taxes can change the pattern of demand by varying relative prices (e.g. an increase in the real duty on petrol)
  • Many indirect taxes make the distribution of income more unequal because of their regressive effects
  • Indirect taxes can be used as a means of making the polluter pay and “internalizing the external costs” of production and consumption
  • Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation expectations
  • Indirect taxes are less likely to distort choices between work and leisure and have less of a negative effect on work incentives.
  • If indirect taxes are too high – this creates an incentive to avoid taxes through “boot-legging”
  • Indirect taxes can be changed more easily than direct taxes – this gives policy-makers more flexibility.
  • Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession causing a fall in consumer spending
  • Indirect taxes are less easy to avoid
  • There is a loss of welfare from duties e.g. loss of producer & consumer surplus
  • Indirect taxes provide an incentive to save that help to provide finance for investment
  • Higher indirect taxes affect households on lower incomes who are least able to save

The overall burden of taxes in a country is measured by the tax burden - this is total tax revenues each year divided by the level of GDP. There are big differences in the tax burdens across economies - some of these are summarised in the table above.

Tax Competition between Nations

  • Tax competition describes a process where a national government decides to use reforms to the tax system as a deliberate supply-side strategy aimed at attracting new capital investment and jobs into their economy.
  • The issue has become important in the European Union because some countries including France and Germany complain that poorer countries are using tax competition as an incentive to attract inward investment, yet they are also net recipients of EU structural funds.
  • If these countries can afford to lower business taxes, can they also afford not to do with the extra EU funding that helps to finance, for example, infrastructural spending required sustaining fast rates of economic growth?

The Laffer Curve

  • Created by the US supply-side economist Arthur Laffer, this curve explores a relationship between tax rates and tax revenue collected by governments
  • It argues that as tax rates rise, total tax revenues grow at first but at a diminishing rate.
  • There may be a tax burden which yields the highest tax revenues. Beyond this, further hikes in taxation serve only to lower revenues
  • The Laffer curve has been used as a justification for cutting taxes on income and wealth - the argument being that improved incentives to work and create wealth will broaden the base of tax-paying businesses and individuals and also reduce the incentive to avoid and evade paying tax.
  • A Keynesian view on the effects of tax reductions on government tax revenue is that lower direct taxes stimulate higher spending within the circular flow which itself boosts demand, output, profits and employment, all of which can drive tax revenues higher.

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