💰 1. Raising revenue
Taxes pay for public services and for the government spending you met in the last lesson. For many governments this is the main reason for taxing.
Fiscal Policy » Taxation: Reasons and Types of Tax
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.2.3
- What a tax is and the six reasons governments tax
- Progressive, regressive and proportional taxes, with figures
- The difference between direct and indirect taxes, with examples
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Unlock This CourseWhat is a tax and why do governments use them?
Look at the last lesson again. Governments spend money on schools, hospitals and roads, and that money has to come from somewhere. Most of it comes from taxes.
Key terms:
- Tax: a compulsory payment to the government by households and firms. You cannot choose to opt out.
Raising money is the most obvious reason for taxes, but not the only one. The spec lists six reasons for taxation.
🚬 2. Discouraging demerit goods
A tax makes a harmful good more expensive, so people buy less of it. The government also collects revenue from the people who still buy it.
🚢 3. Reducing imports
A tax on imported goods makes them dearer than home-made goods. Households switch to home-produced goods, so imports fall. How this works is covered in the lesson on methods of protection.
⚖️ 4. Redistributing income
Taxing richer people more heavily and using the money for benefits and public services narrows the gap between rich and poor.
📈 5. Influencing total demand
Higher taxes leave people with less disposable income, so they spend less and total demand falls. Lower taxes do the opposite and total demand rises.
🌿 6. Encouraging environmental sustainability
A tax on pollution or on fuel makes polluting more expensive. Firms and households cut back or switch to cleaner choices.
Progressive, regressive and proportional taxes
One way to classify taxes is by what happens to the percentage of income that people pay as their income changes. Notice that this is about the percentage, not the amount in dollars.
Key terms:
- Progressive tax: a tax where the percentage of income paid in tax rises as income rises.
- Regressive tax: a tax where the percentage of income paid in tax falls as income rises.
- Proportional tax: a tax where the percentage of income paid in tax stays the same at every income level.
Here are made-up figures for three taxes in the country of Telvonia. The currency is the Telvonian dollar ($).
| Tax | Income $1,000 | Income $4,000 | Income $10,000 | Type |
|---|---|---|---|---|
| Tax A: 10% on income up to $2,000, 20% up to $6,000, 30% above (rate applies to the whole income) | $100 (10%) | $800 (20%) | $3,000 (30%) | Progressive |
| Tax B: flat tax of $20 per person | $20 (2%) | $20 (0.5%) | $20 (0.2%) | Regressive |
| Tax C: 10% of income | $100 (10%) | $400 (10%) | $1,000 (10%) | Proportional |
Worked example
A worker in Telvonia earns $4,000 and pays $800 in Tax A. Percentage of income paid = $800 ÷ $4,000 × 100 = 20%. A worker earning $10,000 pays $3,000, which is 30%. The percentage goes up as income goes up, so Tax A is progressive.
Notice that in a proportional tax, the rich still pay more dollars than the poor. They just pay the same percentage. In a regressive tax, a rich person might pay the same dollars (Tax B), but it takes a smaller share of their income.
Progressive taxes help to redistribute income, because richer people give up a larger share. Regressive taxes do the opposite, because they take a bigger bite out of poorer people's incomes.
Direct and indirect taxes
The second classification is about who actually pays the tax to the government.
💼 Direct tax
A tax paid straight to the government by the person or firm whose income or wealth is being taxed. The person who pays it bears the burden.
Examples: income tax, corporation tax (tax on firms' profits), wealth tax.
🛍️ Indirect tax
A tax on spending. The seller pays it to the government, but the cost is usually passed on to the consumer in the price.
Examples: sales tax, value added tax (VAT), and excise duties on goods such as fuel or alcohol.
Key terms:
- Direct tax: a tax paid directly to the government by the person or firm on whose income or wealth it is charged.
You met indirect taxes in an earlier lesson, where they shifted the supply curve. Here we use the word to classify the tax. Many indirect taxes are regressive, because a poorer household spends a larger share of its income on taxed goods such as fuel than a richer one does. Income tax in many countries is progressive, but a country can choose any design it likes.
Remember that the classifications overlap. Income tax is a direct tax and usually progressive. A flat sales tax is an indirect tax and is often described as regressive.
Common mistakes
Common mistakes
- Saying a tax is progressive because rich people pay more dollars. Look at the percentage of income instead. Richer people pay more dollars under a proportional tax too.
- Mixing up regressive and proportional. Regressive means the percentage falls as income rises; proportional means it stays the same.
- Thinking a direct tax is "direct" because the government sets it. Direct and indirect describe who pays the tax to the government.
- Writing "to raise money" and nothing else. Give the reason, then link it to how the tax works.
Exam-style question
In the country of Penvara, every household must pay a flat $60 water tax each year. Household A has an income of $6,000 a year. Household B has an income of $30,000 a year. The government also puts a tax on petrol to discourage driving.
(a) Define a direct tax. [2 marks]
(b) Calculate the water tax as a percentage of the income of each household. [2 marks]
(c) State whether the water tax is progressive, regressive or proportional, and explain your answer. [2 marks]
(d) Explain two reasons why a government might tax petrol. [4 marks]
Model answer
(a) A direct tax is a tax paid straight to the government (1) by the person or firm whose income or wealth is taxed (1).
(b) Household A: $60 ÷ $6,000 × 100 = 1% (1). Household B: $60 ÷ $30,000 × 100 = 0.2% (1).
(c) It is a regressive tax (1), because the percentage of income paid falls as income rises, from 1% to 0.2% (1).
(d) Reason one: to raise revenue (1) that the government can spend on services such as roads and schools (1). Reason two: to encourage environmental sustainability (1), because dearer petrol makes people drive less and cause less pollution (1).
Exam tip
In a "type of tax" question, work out the percentage of income for at least two incomes before you write the label. The comparison is your explanation.