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Direct & Indirect Taxation

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Direct versus Indirect Taxation

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

Indirect taxes – include VAT and a range of excise duties on oil, tobacco, alcohol. 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 and thereby affecting demand (e.g. an increase in the real duty on petrol) Many indirect taxes make the distribution of income more unequal because indirect taxes are more regressive than direct taxes
They are an instrument in correcting for externalities – 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 the choices that people have to between work and leisure and therefore 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” – e.g. the booze cruises to France where duty on alcohol and cigarettes is much lower.
Indirect taxes can be changed more easily than direct taxes – this gives policy-makers more flexibility. Direct taxes can only be changed once a year at Budget time 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, often people are unaware of how much in duty and other spending taxes they are paying There is a potential loss of welfare from duties e.g. loss of producer & consumer surplus
Indirect taxes provide an incentive to save savings help to provide finance for capital investment Higher indirect taxes affect households on lower incomes who are least able to save
Indirect taxes leave people free to make a choice whereas direct taxes leave people with less of their gross income in their pockets Many people are unaware of how much they are paying in indirect taxes – they may be taxed by stealth – this goes against one of the basic principles of a tax system – that taxes should be transparent

The Tax Base

  • The tax base refers to the number of tax-paying agents in the economy and the amount of income, wealth and spending on which taxes are applied
  • When an economy is expanding, so does the tax base. There are more people in work, businesses are growing and making more profits. And both prices and incomes tend to rise, all of which leads to a rise in tax revenues flowing into the Treasury
  • The reverse happens during a recession. Indeed one of the features of the recession has been the slump in tax income for the UK government – a feature of the downturn that has contributed hugely to the rising budget deficit.

Fiscal Drag

  • Fiscal drag occurs when tax allowances do not rise in line with prices and incomes
  • The result is that people and businesses end up paying a larger percentage of their incomes in tax and revenues to the government can rise quickly.

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?
  • During the 2010 financial crisis in Ireland, some countries were putting pressure on Ireland to cut their low corporation tax rate of 12% as price for their emergency bail-out. Ireland refused to do this.

Flat Rate Taxes

A ‘flat tax’ means that everyone is taxed at just one rate. I.e. everyone pays the same percentage tax on any income earned above the tax threshold. Examples of countries that have moved towards flat rate tax systems include Estonia, Latvia, Poland, Lithuania, Russia, Slovakia and Hungary. Supply-side economists are often fans of flat rate taxes because they think that they will

  1. Help reduce red tape and reduce the resources wasted on tax forms, chasing up non-payers and enforcing tax laws. This would reduce the money spent on administering the tax system.
  2. Boost incentives for people to work, to save (e.g. for retirement) and for companies to use profits to invest - both of which could increase the country’s potential growth rate.
  3. Generate increased tax revenue – based on the idea of the Laffer Curve
  4. A flat tax may make an economy more attractive to foreign investment.

Arguments against

  1. Flat rate taxes are no longer progressive and so the distribution of income and wealth will be more unequal – certainly in the short and medium term.
  2. Flat taxes can form part of a “race to the bottom” with governments competing with each other to offer the lowest rates of tax to entice inward investment and skilled workers.
  3. If tax rates are cut, some people may choose to work less because they can earn the same income from working fewer hours.
  4. There is no guarantee that businesses will engage in more investment and R&D if company taxes are lower – they may simply offer more in the way of dividends to their shareholders!

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