4/13/2020 5.

2 – Taxation – IGCSE AID

Taxation

What are taxes?

Taxes are a compulsory payment made to the government by all people in an economy.

Why Taxes?

Taxes are incurred for several reasons:

Taxes are a major source of government revenue used to finance all government expenses.
To manage the macroeconomy through fiscal policy (taxes are used in fiscal policy see Topic
5.1)
To promote equality in income between the poor and the rich. People with higher incomes are
taxed heavier that people with low incomes.
To discourage the consumption and production of demerit goods (alcohol, tobacco). How
taxes affect production and consumption will be discussed later in this topic.
To protect the environment. More tax can be imposed on firms and products that create a lot of
pollution and environmental damage.

Tax Systems

Progressive Taxes: the proportion of income taken into tax rises as income rises. That is, people
with higher incomes are taxed heavier that people with low incomes.

Regressive Taxes: the proportion of income paid in tax falls as income rises. That is taxes fall
heavily on the poor than the rich.

Proportional Taxes: the proportion of income paid as tax is same whatever the income.

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4/13/2020 5.2 – Taxation – IGCSE AID

Direct Taxes: tax on individual or firm’s income or wealth. The burden of tax payment falls
directly on the person or individual responsible for paying it. They include income taxes (on
people’s income), corporation taxes (on a firm’s profits), capital gain taxes (on property and other
valuable assets), and inheritance tax (on inheritance of valuable assets).
They are progressive taxes as more the income, more the tax levied.

Advantages:

High revenue: as all people above a certain income level have to pay income taxes, the revenue
from this tax is very high.
Can reduce inequalities in income and wealth: as they are progressive in nature- heavier taxes
on the rich than the poor- they help in reducing the difference between the income levels of the
rich and the poor.

Disadvantages:

Reduce work incentives: people may rather stay unemployed (and receive govt.
unemployment benefits) rather than be employed if it means they would have to pay a high
amount of tax. Those already employed may not work productively, since any extra income
they make, the more tax they will have to pay.
Reduce enterprise incentives: corporation taxes may demotivate entrepreneurs to set up new
firms, as a good part of the profits they make will have to be given as tax.
Tax evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus tax
revenue falls and the govt. has to use more resources to catch those who evade the taxes.

Indirect Taxes: taxes on the goods and services sold (it is called indirect because it indirectly takes
money as tax from consumers incomes). Indirect taxes are normally paid by producers, but they
will shift the tax burden onto consumers by fixing higher prices.They include ad valorem taxes,
sales taxes, tariffs and customs duty (on imported goods and service) and excise duties (on harmful
goods such as cigare es and alcohol) all added to the price of a product.
They are regressive taxes; even though all consumers pay the same tax, it will take more
proportion of income of the poor, thus falling heavily on them than the rich.

Advantages:

Cost -effective : the cost of collecting indirect taxes are low compared to direct taxes.
Expanded tax-base: directs taxes are paid by those who make a good income, but indirect taxes
are paid by all people (young,old,unemployed etc) who consume goods and services.
Can achieve specific aims: for example, excise duty (tax on demerit goods) can discourage the
consumption of harmful goods; similarly, higher and lower taxes on particular products can
influence their consumption.
Flexible: indirect tax rates are easier to alter/change than direct tax rates. Thus their effects are
immediate in an economy.

Disadvantages:

Inflationary: The prices of products will increase when indirect taxes are added to it, causing
inflation.
Regressive: since all people pay the same amount of money, irrespective of their income levels,
the tax will fall heavily on the poor than the rich as it takes more proportion of their income.
Tax evasion: high tariffs on imported goods or excise duty on demerit goods can encourage
illegal smuggling of the good.

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