We now focus on taxation. Taxation is any compulsory levy from private sector households and businesses to the government in the form of direct or indirect taxes.

The main objectives of the UK tax system

The current government's objectives for the British tax system are broadly as follows:

• The burden of tax: To keep the tax burden as low as possible (the burden of tax for a country can be measured by the % of GDP taken in taxes and is shown in the chart above)
• To improve incentives: The government believes that reducing tax rates on income and business profits helps to sharpen incentives to work and create wealth in the economy as a strategy to enhance long-run growth
• Tax spending rather than income: To shift the balance of taxation away from taxes on income towards taxes on spending – this is because it is thought that taxes on income have a greater effect on work incentives
• Equitable taxes: To ensure taxes are applied equally and fairly to everyone. Equality is not always the same as fairness – see the notes below on the canons of taxation
• Correct for market failure: As with many other governments in other countries, the UK government believes in the use of taxes to make markets work better (including taking account of externalities) – this is an important microeconomic objective. The government is committed to using the tax system as an instrument of correcting for market failures.

The table below shows the main sources of direct and indirect tax revenues for the UK projected for the 2004-05 financial year. Income tax and national insurance contributions together account for over £205 billion of government tax revenues each year. VAT is the biggest single source of indirect tax revenue although over £40 billion of revenue comes each year from excise duties.

Income from taxation for the UK government	1999-00	2004-05
	£ billion	£ billion
Income tax	95.7	127.2
National Insurance contributions	56.1	78.1
VAT	56.4	73.0
Corporation tax	34.3	34.1
Fuel duties	22.5	23.3
Council Tax	13.1	20.1
Business rates	15.4	18.7
Other taxes	8.1	11.7
Stamp duties	6.9	9.0
Tobacco duty	5.7	8.1
Vehicle excise duty	4.9	4.7
Beer & cider duties	3.0	3.3
Inheritance tax	2.1	2.9
Spirits duties	1.8	2.4
Insurance Premium tax	1.4	2.4
Capital gains tax	2.1	2.3
Wine duties	1.7	2.2
Customs Duties & levies	2.0	2.2
Betting & Gaming duties	1.5	1.4
Petroleum revenue tax	0.9	1.3
Air Passenger duty	0.9	0.9
Climate Change Levy	0.0	0.8
Land fill tax	0.4	0.7
Aggregates levy	0.0	0.3
Oil royalties	0.4	0.0

 

What are the principles of a good tax system?

If you were creating a new tax system from scratch, what would be the main principles on which your system might be based? One set of principles known as the canons of taxation was developed by classical economist Adam Smith in his famous work on the ‘Wealth of Nations’ published in the late 18th century. When you are asked to discuss the justification for different forms of taxation, it is often worth coming back to these principles when evaluating the relative merits and de-merits of alternative forms of taxation

• Efficiency - an efficient tax system raises sufficient revenue to pay for government spending, without creating negative distortions such as reducing work-incentives for individuals and investment incentives for companies
• Equity – the principle of equity is that taxes should be fair and based on people's ‘ability to pay’.  Income tax satisfies this condition because it is a progressive tax system, the marginal and average rate of tax rises with income – but some indirect taxes may not – for example the duty on cigarettes is said to have a regressive effect on the overall distribution of income
• The ‘benefit principle of taxation’ – this principle is that taxes paid by people have a link with the benefit that the person paying the tax actually receives from government spending. However, there are some problems with too much emphasis on the benefit principle. Firstly if ignores the redistributive aims of taxation. For example, the government might introduce a new tax or raise an existing one with purely redistributive aims in mind i.e. a desire to reduce relative poverty.  The benefit principle is mainly concerned with allocative efficiency rather than equity. A second problem is that 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 (consider the ‘free rider problem’). It is also difficult for the government to assess individual benefits from public goods.
• Transparency and certainty - taxpayers should understand how the system works and should be able to plan their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to evade – we know that in many countries there is a fast-growing industry that provides information to people on how to reduce their tax liabilities. Collection costs should be kept to an acceptable level so that the costs of collection are very low relative to the total tax revenues collected.

The progressivity of the income tax system in the UK

To what extent does the income tax system work to reduce the gap between the highest and lowest paid households in the UK? In a progressive tax system the average rate of tax rises with income. And we see from the table below that income tax is indeed progressive in its effects on disposable income. The average rate of tax rises from around 5% on incomes between £7,500 - £9,999 to three times for people in the £20-£30k income bracket. For people earning over £50,000 per year, over a quarter of their income is paid directly in income tax.

But the system is not as progressive as it might be and as it was over twenty years ago. The extent of the "progressivity" of the income tax system has been reduced over the years. Before 1979, the top rate of income tax was 83 per cent, with a 15 per cent supplement for investment income. Now most taxpayers face a similar marginal tax rate of 22% compared with a top rate of 40 per cent but on top of the basic rate there is national insurance contributions (NICs) at 11 per cent and 1 per cent extra on NICs for higher earners, making the overall rates 33 per cent, and 41 per cent. This is not such a great progression. If a government wanted to use the income tax system to achieve a more even final distribution of income, it could

• Raise the top rate of income tax above 40%
• Increase the tax free allowance for people
• Introduce lower marginal rates of tax for lower-income households

Income tax payable: by annual income, in 2005/06
	Number of taxpayers (millions)	Total tax liability (£ million)	Average rate of tax (percentages)	Average amount of tax (£)
£4,895–£4,999	0.1	1	0.1	5
£5,000–£7,499	2.9	369	2.0	126
£7,500–£9,999	3.5	1,580	5.1	445
£10,000–£14,999	6.1	7,560	9.8	1,220
£15,000–£19,999	5.1	11,500	13.0	2,260
£20,000–£29,999	6.4	24,000	15.4	3,760
£30,000–£49,999	4.3	28,900	17.9	6,690
£50,000–£99,999	1.5	25,900	25.7	17,000
£100,000 and over	0.5	34,200	33.4	71,100
All incomes	30.5	134,000	18.2	4,390
Source: Social Trends 36, ONS

The easiest thing to do would be to increase the higher rate of income tax but this might create incentive problems in the labour market.

Direct versus Indirect Taxation

• Direct taxes – are paid directly to the Exchequer by the individual taxpayer – usually through “pay as you earn”. The same is true of corporation tax. Tax liability cannot be passed onto someone else
• Indirect taxes – include VAT and a range of excise duties on oil, tobacco, alcohol. The burden of an indirect tax can be passed on by the supplier to the final consumer – depending on the price elasticity of demand and supply for the product.

In the last twenty years there has been a shift towards indirect taxation – economists differ in their views about what is the optimum mix of taxation between indirect and direct taxes

Arguments For Using Indirect Taxation	Arguments Against Using Indirect Taxation
Changes in indirect taxes are more effective in changing the overall pattern of demand for particular goods and services i.e. in changing relative prices and thereby affecting consumer demand (e.g. an increase in the real duty on petrol)	Many indirect taxes make the distribution of income more unequal (less equitable) because indirect taxes are more regressive than direct taxes
They are a useful instrument in controlling and correcting for externalities – all governments have moved towards a more frequent use of indirect taxes 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. Higher indirect taxes allow a reduction in direct tax rates (e.g. lower starting rates of income tax)	There is no hard evidence that cutting direct tax rates has much of an incentive effect on people’s decisions about whether or not to work. If indirect taxes are too high – this creates an incentive to avoid taxes through “boot-legging” – a good example of this would be attempts to evade the high levels of duty on cigarettes
Indirect taxes can be changed more easily than direct taxes – this gives economic policy-makers more flexibility when setting fiscal policy. 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 consume spending
Indirect taxes are less easy to avoid by the final tax-payer who might be unaware of how much indirect tax they are paying	There is a potential loss of economic welfare (taxes can create a deadweight loss of consumer and producers surplus)
Indirect taxes provide an incentive to save (and thereby avoid the tax)- a higher level of savings might be used by the economy to finance a higher level of capital investment	Higher indirect taxes affect households on lower incomes who are least able to save in the first place
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 – this goes against one of the basic principles of a good tax system – namely that taxes should be transparent

 

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 (the tax-free allowance. A similar system is often used for corporate taxes – taxes on company profits and also on indirect taxes such as VAT.

The size of the tax free allowance is an important issue – it needs to be large enough to persuade people to prefer paying taxes rather than avoiding them. But if it is set too high, then the government may not get enough tax revenue to pay for government spending. Some theorists in favour of flat taxes have suggested the countries should introduce a large personal allowance, with the most detailed research by the Adam Smith Institute hinted at a £12,000 personal allowance up from the current rate of £4895.

Examples of countries that have moved towards flat rate tax systems include Estonia, Latvia, Poland, Lithuania, Russia, Slovakia and most recently, Hungary. From being a theoretical curiosity in the lecture halls for university economics courses, flat taxes are now being applied in different countries and there is an active debate about their merits and demerits.

Why have flat rate taxes?

Supply-side economists are often fans of flat rate taxes because they think that they will

• Help reduce red tape and reduce the resources wasted on tax forms, chasing up non-payers and enforcing complex tax laws. This would reduce the money spent on administering the tax system.
• Reduce inequity (because there is the same tax rate for all) – and having a generous tax free allowance is good news for low income families, improving their incentives to earn extra income.
• 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.
• Generate increased tax revenue – based on the idea of the Laffer Curve – that cutting tax rates can actually boost the supply-side so much that the government ends up with more tax revenue coming in allowing it to finance increased spending on priority areas.
• A flat tax may make the British economy more attractive to foreign investment. In a global economy in which investors can move freely across country borders, a simple fiscal system attracts inward investment.
• A lower level flat rate tax on savings will positively impact the household savings ratio and thereby have a positive impact on future economic growth. Increased saving would help protect developed economies from threats, such as huge pension deficits, one of the biggest structural threats to developed economies. It can also help to provide the funds for future investment strengthening growth and raising living standards. Currently, income tax is considered to hamper saving and the introduction of a flat rate tax is expected increase the saving rate. The key reason for this is the double taxation of personal savings, firstly on income and secondly on investment income or, once on company profits then on dividends.

Arguments against

• Flat rate taxes are no longer progressive (at least as far as the 'marginal' rates are concerned) and so the distribution of income will become more unequal – certainly in the short and medium term.
• Flat rate taxes tend to favour the wealthy at the expense of the poor because the wealthy are no longer taxed at high rates on their savings, their dividend incomes and their inheritance wealth.
• 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. The result is a widening gap between the wealthy and the poor and less revenue for the government to commit to social welfare spending.
• There is no guarantee that people will look to work more if tax rates are lower, indeed some people may choose to work less because they can earn the same income from working fewer hours.
• 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!
• Tax reforms such as flat taxes are not the only key factor in determining flows of foreign investment around the world economy. John Chambers CEO of Cisco Systems has been quoted as saying that “Jobs are going to go where the best-educated workforce is with the most competitive infrastructure and environment for creativity and supportive government.”  In addition people living in those respective countries do not want to see a reduction in spending on their services at the benefit of reduced taxation. 

Suggestions for further reading and research

• Flat tax creator turns critic (BBC news)
• East Europeans opt for flat-rate tax (BBC news)
• Flat tax, the British case (Adam Smith Institute)

The Laffer Curve

The Laffer Curve is a theory built on the incentive effects of lower taxation which suggests that total tax revenue coming into the government may increase at a lower tax rate. As the tax rate further increases, the marginal revenue from lower taxes may tend to fall at an increasing rate up to optimal tax revenues, at tax rate X. After this point, any increase in the tax rate prompts people to work less, or to do more to avoid the tax, thereby reducing total revenue as the opportunity cost of paying the tax rises. Hypothetically at a 100 percent tax rate, nobody would have any incentive to work at all, since the Government collects everything people earn. Laffer’s ultimate prediction is if you cut taxes you can increase tax revenues and create a virtuous circle.