This article introduces Direct TAXation and Indirect TAXation. It also explains reasons for TAXation. Finally, it describes the impact of TAXation on incentives through The Incentives Effect.
Direct TAXation and Indirect TAXation
Direct TAXes are levied on an individual’s or a firm’s income. This TAX cannot be passed on to another economic agent. Examples of Direct TAXes include Income TAX which is calculated using an individual’s salary, and Corporation TAX which is calculated using a firm’s profit.
Indirect TAXation is a TAX paid on goods and services, like Value Added Tax (VAT) which is a TAX included on almost all goods and services. VAT is calculated as a percentage of the value of the good or service.
General reasons for TAXation
There are many reasons why governments impose TAXes on firms and households including the following:
- Pay for government expenditure
- Correct market failure
- Redistribute income
- Manage the economy
1. Pay for government expenditure
TAX is the government’s main source of income used to finance government spending.
Governments may borrow money, if TAX income is not enough to cover spending plans, i.e. if there is a budget deficit. TAXation allows the government to invest in the economy, including the provision of public goods and merit goods. Public goods include public education, health care services, the police force, military, street lighting, etc.
2. Correct market failure
Governments can intervene in markets, if they feel that the market is failing to allocate resources in a desirable manner. They may increase TAXes on products that create negative externalities in society, such as cigarettes and alcohol. Such TAX increases can help to reduce demand for these demerit goods causing resources to be reallocated to other more beneficial uses.
Alternatively, government may give a TAX break to companies producing products which benefit society aka positive externalities such as new medications, clean energy sources, energy-efficient home appliances, etc. A TAX break means that the producer is not required to pay TAX, whereas a TAX cut means a reduction in the TAX levied.
Other examples include ‘green TAXes’ or ‘environmental TAXes’ which are imposed on products or industries which damage the environment, e.g. petrol and manufacturing processes releasing carbon dioxide or other chemicals. The intention is that by TAXing these kind of businesses pollution will be reduced as the desire to produce and consume decreases.
3. Redistribute income
TAXes can be used to reduce the wealth gap which is the financial difference between the rich and the poor in a society.
The wealth gap is a concern as inequality or a widening of the wealth gap can lead to social unrest, if people are forced into poverty. Consumers can be forced out of markets which is a concern when the goods or services are necessities or merit goods such as access to doctors. The government can act by using TAXes to take money from high earners and distribute more to low income families.
Though the redistribution of income may be seen as unfair and be a disincentive to work for high earners, the common benefits to the poorer groups are greater than the losses to the richer groups.
4. Manage of the economy
TAXation has an effect on the economic environment and the performance of the macro economy.
TAXation policy can be used to cause changes to levels of inflation, unemployment and even the trade balance. Therefore, Aggregate Demand (AD) and Aggregate Supply (AS) are also influenced as a result of prices and incomes being directly affected.
The Incentive Effect
Direct TAXes can have an effect on an individual’s incentive to work.
- The ‘income effect’ is where TAX reduces incomes and so people choose to work more in order to compensate for the loss of disposable income.
- The ‘substitution effect’, is where TAX reduces incomes and so the opportunity cost of leisure is reduced. Therefore, people choose to work less as they view the benefits of leisure to be greater than the benefits of working.
An example of how this is useful information to a government is labor force participation rates.
In the UK, efforts were made to encourage women to return to work after having a family. Governments needed to set TAXes so that secondary family incomes were worthwhile earning. If TAXes were too great, then many women interested in returning to work may not have done so.
Summary about TAXation
TAXes allow the government to provide necessary services that people would not access or could not afford to pay for otherwise. TAXes can also be used to make a more equitable society and maintain a higher standard of living.
