Taxes are important for a number of reasons. In the UK, the government provides health care, defence and education, as well as things like libraries. These services are paid for (taxes) and produced by the public sector. The government also pays the private sector for goods and services such as new roads and electricity for street lamps.
Taxes can also be used to change demand in certain markets, in order to promote or discourage activity. For instance, by imposing taxes on goods with negative externalities, such as alcohol and pollution producing services, demand is decreased and so are the negative side effects of production. Similarly, by exempting books from VAT, demand increases, resulting in a more books being bought and read.
Governments may alter the tax rate in order to manage the economy as a whole. The tax rate can influence unemployment, inflation and the balance of payments, and being able to alter it is useful for the government should they need to change these variables. For example reducing tax may result in consumers having more income, which may result in them buying more imports.
Finally, taxes enable governments to redistribute income and wealth from rich groups in society to poorer groups, resulting in a more equitable system. Examples of this include Social Security benefits and pensions.
“In recent years UK governments, irrespective of political barrier, have changed the structure of UK taxes.”
Why have they done this? What have been the consequences?
There are two classifications of taxes. A direct tax is a tax levied directly on an individual or organisation, such as income tax. Indirect taxes, on the other hand, are levied on goods and services, such as value added tax (VAT).
Before 1975, governments mainly applied Keynesian policies of using taxes to manage Aggregate Demand (the sum of all spending in an economy). Cutting taxes and increasing public spending in order to put the economy into a boom in 1972-3 ended disastrously after the ‘Barber Boom’ it caused, as inflation span out of control. A classical model of the economy became more popular for governments to work with. The government tried to tackle the problems raised by AD management by implementing Supply Side policies. Supply side policies aim to increase the productive potential of an economy, and supply side issues also help to explain economic events. For instance, a high income tax may cause disincentives to work, as the reward it not so high. High taxes on profits made by a firm (corporation tax) cause a disincentive to enterprise: in order to encourage enterprise, we must reduce this tax.
Investment by firms increases the capital stock (factories, offices) of a country, which boosts the AS curve. Firms invest in order to make a profit. If the government reduces corporation tax or provide investment allowances, more investment will take place.
High marginal rates of direct taxation, income tax in the case of workers, undermine the economic incentives to work. By cutting high rates of direct taxation, there is an increase in the benefits obtained by working. As a result, work is substituted for leisure (the opportunity cost), and people work more hours, accept promotion, or are more willing to join the workforce.
There are limitations to this system, for example, the extra income earned by people due to a cut in direct taxes may result in a ‘laziness’ effect, as people get more money for doing nothing extra.
Despite the cuts the government have made in direct taxes from the late 70s onwards, revenues from taxable income have risen. This is due to the reduction or abolishment of allowances, such as child allowances, as well as economic growth raising the taxable income of the nation and reductions in the top rate of tax reducing people’s incentive to avoid tax.
VAT rates have risen from 8 percent in 1979 to 17.5 percent today. Also, VAT has been introduced on domestic fuel which was previously zero rated. Indirect taxes, such as VAT, tend to be a regressive tax. A regressive tax is a tax where the proportion of income paid falls as income rises. This type of tax is deemed inequitable, as the ability to pay tax is not taken into account: people on higher incomes should pay more tax, as they can afford it.
Progressive taxes are taxes where the proportion of income paid increases as the income of the tax payer increases. Income tax is progressive; when income rises above a certain amount, each extra pound earned is taxed at a higher rate. This method of taxation is seen as equitable, as people with higher income are able to pay more.
From the early 80s, the burden of taxation has been shifted from better to worse off, as the cuts in higher band income tax and the introduction of the poll tax took effect. From the early 90s, however, the poll tax was replaced by the council tax and income tax cuts favoured the less well off. Overall, the tax system remains slightly progressive.