Taxation: Types, Principles and the Incidence of Tax
Taxation can be classified as direct (levied on income or wealth, e.g. income tax, corporation tax, paid straight to the government by the person or firm who bears it) or indirect (levied on spending, e.g. VAT, added to the price of a good).
Before you start
Make sure you're comfortable with these topics first:
Method
- Classify the tax in the question as direct or indirect.
- Test whether the tax is progressive, regressive or proportional by calculating the average rate of tax (tax paid divided by income) at two or more income levels and comparing how it changes.
- Where relevant, apply Adam Smith's canons of taxation (equity, certainty, convenience, economy) to judge whether a tax is well designed.
- For an incidence question, compare the price elasticity of demand (PED) and price elasticity of supply (PES) for the taxed good: the side of the market that is relatively more price inelastic bears the larger share of the tax burden.
- Use a supply and demand diagram to show the tax as a vertical wedge between the price consumers pay and the price producers receive, and shade the consumer and producer shares of the burden.
- Link the type of tax to fiscal policy and macroeconomic objectives: progressive direct taxes act as automatic stabilisers, while indirect taxes can be used to correct externalities or to raise revenue with different effects on work incentives.
- Evaluate using the Laffer curve logic: raising a tax rate does not guarantee higher tax revenue, because very high rates can discourage work effort, encourage tax avoidance or evasion, or drive economic activity abroad, so there is a revenue-maximising rate beyond which further rises can reduce revenue.
Worked example
A government imposes a specific tax of 2 pounds per unit on a good. Before the tax, the price was 10 pounds. After the tax, the price paid by consumers rises to 11.20 pounds, and the price received by producers falls to 9.20 pounds. Calculate the consumer's share and the producer's share of the tax burden, and state which side of the market is relatively more price inelastic.
- Calculate the consumer's burden: 11.20 - 10.00 = 1.20 pounds.
- Calculate the producer's burden: 10.00 - 9.20 = 0.80 pounds.
- Check the two shares sum to the total tax: 1.20 + 0.80 = 2.00 pounds, which matches the tax imposed.
- Express each as a share of the total tax: consumer share = 1.20 / 2.00 x 100 = 60%; producer share = 0.80 / 2.00 x 100 = 40%.
- Conclude: since consumers bear the larger share (60%) of the tax, demand for this good is relatively more price inelastic than supply.
Practice questions
Try each question, then tap to reveal the answer.
Q1Give one example of a direct tax and one example of an indirect tax.Show answer
Answer: For example, income tax (direct) and Value Added Tax, VAT (indirect).
Q2A person earning 20,000 pounds pays 2,000 pounds in tax; a person earning 40,000 pounds pays 6,000 pounds in tax. Calculate the average rate of tax for each and state whether the tax system shown is progressive, proportional or regressive.Show answer
Answer: 20,000 pounds earner: 2,000 / 20,000 x 100 = 10%. 40,000 pounds earner: 6,000 / 40,000 x 100 = 15%. The average rate rises as income rises, so the system is progressive.
Q3Name Adam Smith's four canons of taxation.Show answer
Answer: Equity, certainty, convenience and economy.
Q4What does 'tax incidence' mean?Show answer
Answer: How the burden of a tax is actually shared between consumers and producers, as opposed to who is legally required to pay it to the government.
Q5Explain what the Laffer curve shows.Show answer
Answer: It shows the relationship between the tax rate and total tax revenue, illustrating that revenue rises with the tax rate up to a point but can then fall if rates go so high that they discourage economic activity.
Q6If demand for a good is perfectly price inelastic, who bears the entire burden of an indirect tax on it?Show answer
Answer: Consumers bear the entire burden, since they will buy the same quantity regardless of the price rise.
Q7State whether VAT is generally considered progressive or regressive, and explain why in one sentence.Show answer
Answer: Regressive, because lower-income households spend a larger proportion of their income on VAT-rated goods than higher-income households do.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
A household earning 15,000 pounds a year pays 1,050 pounds in a particular tax. A household earning 60,000 pounds a year pays 3,600 pounds in the same tax. Using this data, calculate the average rate of tax paid by each household and determine whether the tax is progressive, proportional or regressive.
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Evaluate the case for shifting the balance of UK taxation away from direct taxes and towards indirect taxes.
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