Grade 9

Economicsweek 2

Direct taxes Income tax Personal income tax is a tax payable from an individual's earnings usually 00 a pay-as-you-earn basis. Most countries allow people to earn a certain amount of income that is tax-free, usually known as a personal allowance. For exarnpl a person in the UK could earn up to £11,000 in the 2016-17 tax year without e, having to pay any income tax.

Exactly how much tax a person pays in income tax will depend on how much they earn and in some cases their personal circumstances, for example whether they are single, married, with or without children, old and retired. Income tax in many countries is a progressive tax. That is, higher marginal tax rates are applied to progressively higher slices or parts of a person's income. A marginal tax rate is therefore the percentage taken from the next dollar of taxable income above a pre-defined income threshold. The rate may differ for different groups of people. For example, tax-free allowances and marginal rates of tax tend to be more generous for old people and for people with children so that they pay less tax overall than a person who earns the same amount but is single and has no children.

It is useful to distinguish between the average tax rate a person pays and their marginal tax rate. The average tax rate is the total amount of tax paid by a person divided by their total income. The marginal tax rate is the rate of tax paid on each additional dollar of income. A person could therefore pay many cliff erent marginal rates of tax on their income, especially if they earn a high income. By adding up the amount of tax paid on each additional slide of income the average tax rate can be calculated.

't' A simple progressive income tax structure For example, the diagram above shows a simple personal income tax with 3 income tax bands, each one with a different and progressively higher marginal rate of tax up to 40%. The first income tax band between $1 and $10,000 is the tax-free personal allowance. No tax is payable by any person on the first $10,000 of their annual taxable incomes.

500/o

£ 400/o

~ :! 300/o

"' 200/o C:

"§ i 100/o

00/o

i $10 001 to $50 000

Oto $10 000

Over $50 001

Taxable income bands ($)

't' How to calculate average tax rates

Person with annual income of $25,000

I

Taxable income band ($)

Marginal tax rate (A)

$0-10,000

$10,001-50,000

$50,001 and over

0

200/o

400/o

• Government and the macroeconomy

A person with an annual income of $25,000 will therefore pay a marginal rate of tax of 20% on $15 000 of their income or $3,000 which equates to an a;erage tax rate of 12% ?n a total income of $25,000. In contrast, a person in the highest marginal tax band with an annual income of $l00,000 will pay income tax of $28,000 or an average tax rate of 28% (see the tables below) .

Amount of taxable income marginal rate is applied to (B)

$10,000

$15,000

0

Amount of income tax paid (Ax B)

0

$3,000

0

Total tax paid = $3,000

A'Jerage rate of tax paid (%) = total tax payable x 100 $3 00 total income - == • Ox 100 $25,000 == l 20/o

Person with annual income of $120,000

Taxable income band ($)

$0-10,000

$10,001-50,000

$50,001 and over

Marginal tax rate (A)

0

200/o

400/o

Amount of taxable income marginal rate is applied to (B)

$10,000

$40,000

$50,000

Amount of income tax paid (Ax B)

0

$8,000

$20,000

Total tax paid = $28,000

Average rate of tax paid (%) = total tax p~yable x 100 _ $28,000 x 100 total income - $l00,000 = 280/o

Income tax is a type of payroll tax that employers are required to withhold fr?m the wages of salaries of their employees each week or month. Employees w~H therefore receive their wages or salaries net of tax deducted. Employers will then pay the income tax they have collected to the government's tax authority. People who are self-employed must provide evidence of their annual earnings and will pay their income tax direct to the government usually in a lump sum once or twice each year.

Other payroll taxes Other payroll taxes exist in many countries, for example social security contributions to meet the cost of welfare benefits and old-age pensions provided by government, levies to pay for public healthcare and unemployment insurance to pay towards unemployment benefits. These payroll taxes are often based on an individual's earnings but may be payable from an employer's own funds as well as by an employee. Payroll taxes that have to be paid from an employer's own funds are often called employment taxes because they increase the cost of employing workers.

Corporation tax corporation tax is levied on the profits of limited companies or corporations and may also be called a profits tax if applied to unincorporated businesses, notably sole traders and partnerships. Sometimes a government may also impose a one-off windfall tax on the profits of a company either thought to be a monopoly and making very significant profits, or benefiting from world events that boosted its profits. For example, the UK has from time to time imposed a windfall tax on the _profit~ of o~ coi:ripanies when they ha_ve . enjoyed a significant increase m the1r profits simply as a result of a nse m world oil prices over which they have no direct control.

..,.. ourage new businesses to start up, corporate tax rates on the profits of .10 enc • c · smaller firms are often set at a low_or zero rate in som: countries. orporauon tax rates often rise progressively with the scale of profus.

Capital gains tax . . . . "ble to make a profit from the sale of famous pamtmgs, Jewellery,

It 1s poss1 th h . d · l · p fi nd other valuable assets at ave increase m va ue over nrne. ro ts

property a . . d

• this way are called capital gams and may be taxed by a government. ma em .

. allowances are made, for example for the length of ume someone has someumes

Fiscal policy ■

The impact of direct taxes

held an asset _ the longer someone has held it the lower the tax the person pays. For example, in Canada, only 50% of a capital gain is classed as taxable income.

Taxes on wealth Wealth taxes can include taxes on the value of residential and commercial land and property. Wealth taxes can also include inheritance taxes on the transfer of wealth from one person to another upon their death. When an individual dies and leaves his or her house, savings and/or other valuable possessions to someone else, inheritance tax might be payable on the total value inherited.

Money raised from direct taxes can be used to support many different areas of public expenditure that can benefit people and firms in an economy both directly, for example through the provision of public healthcare, wellare payments and government grants, and indirectly through the impact they can have on economic growth, inflation and job creation.

Advantages of direct taxes Direct taxes also have a number of other advantages:

t/ High revenue yield

The big advantage of direct taxes like income tax and corporation tax, is that they have a high yield of revenue compared to their cost of collection. The total amount of money collected can be estimated with reasonable accuracy in advance, which is of great help to a government when planning how much it can afford to spend.

t/ They can be used to reduce inequalities in incomes and wealth

The progressive nature of many direct taxes means that wealthier members of society are taxed more heavily than poorer groups, to help reduce inequality.

t/ They are based on ability to pay

A direct tax will usually be based on a person's or firm's ability to pay the tax. Family commitments and dependants can also be taken into consideration and a system of tax allowances can be used to reflect these responsibilities.

Disadvantages of direct taxes

However, direct taxes can also have number of negative impacts in an economy especially if direct tax rates are set too high.

)( Raising taxes from incomes reduces disposable incomes and consumer demand

Taxes on personal incomes will reduce disposable income: the amount remaining after income and other payroll taxes have been deducted from earnings that people can 'dispose' of how they wish. Therefore, as income taxes rise,. consumer spending is likely to fall. Firms producing luxury items are most likely to be affected as consumers continue to buy food and other essential items but reduce their spending on expensive and non-essential goods and services. ► 3.2.1

As consumer spending falls the revenues and profits of man firms will decline. In response, ~rms will reduce their prices to sell off unsold it:ms and will also trY to reduce their costs by cutting their workforces and outp t s r· badl)' ff d f llin d

u . ome 1rms a ecte by a g emand may even be forced to clos 1 d ·ng' . e. n contrast, re uo personal mcome taxes can help to boost consumer sp d. d b .· cti·vi(\·.

• Government and the macroeconomy

en mg an usmess a 1

Indirect taxes

L

,c Employer payroll taxes may reduce employment

So~ial ~ontributions paid by employees from their earnings will also reduce their disposable incomes while payroll taxes paid by employers will increase the cost of employing workers. As the cost of employing labour rises firms may reduce their demand for labour and may switch to more capital-intensive methods of production. ► 3.6.2

K H' h · Ig Income and payroll taxes may reduce labour productivity and economic growth

A high tax take from the earnings of workers will reduce their take-home pay and therefore the reward from employment. As result some workers may choo~e not to work while others in work may reduce their effort, stop working overtime or developing their skills to seek promotion and higher wages, especially if the tax system is highly progressive. Lower taxes may instead increase employee motivation resulting in higher levels of output. ► 3.6.3

" Taxes on profits can reduce enterprise and investment

Taxing profits reduces the reward for enterprise and risk-taking. There may be fewer start-ups and less business growth as a result because firms will have less money after taxes to reinvest in expanding their scale of production. For these reasons many countries have been reducing their corporation tax rates over time to help encourage new enterprise, business investment and job creation in their economies.

" High direct tax rates increase tax evasion

As a result tax revenues are lower and a government will spend more on trying to catch those individuals and companies that cheat or lie about their incomes to avoid paying the taxes they are due.

Indirect taxes are added to the prices of goods and services and are therefore collected from transactions made by people and organizations. An indirect tax may be a fixed percentage of a price or value or it may be a fixed amount.

The collection and payment of indirect taxes to government is normally the responsibility of producers who will then pass on as much of each tax as they can to consumers through raised prices. This means the incidence of an indirect tax, i.e. who bears the cost of it, will often be shared between a producer of a pi:oduct and the consumers of that product. For example, in a highly competitive market for a product for which consumer demand is highly price sensitive, producers may be unable to increase their prices to cover the indirect tax. If they do, demand for their product and therefore their revenues may fall significantly. ► 2.7.4

Sales taxes A sales tax is a consumption tax imposed by the government on the sale of finished goods and services. A sales tax can be a fixed amount added to the price of a product or levied as a percentage of its price. Most sales taxes are therefore collected by sellers and then passed on to the government.

Value added tax Value added tax (VAT) is an ad valorem tax. This means it is charged as a percentage of the value of transactions including, for example, payments for electricity, insurance, rent, restaurant bills, tickets for sporting and music events. Unlike a sales tax that is applied only to the final selling price of a

Fiscal policy •