SESSION 4: TAXATION AND FISCAL POLICY 

Government expenditure is required to stimulate total economic demand. However, government expenditures are primarily financed by two sources.

If expenditures exceed income, these are taxation and borrowing. The concentration of this session is on taxation as a component of government fiscal policy. We will also discuss the advantages and disadvantages of the various tax types.

Objectives   At the conclusion of this session, participants will be able to:

1. explain the sources of government revenue
2. appreciate the uses of the tax revenue
3. understand the features of a well-designed tax system
4. explain the types of tax, enumerating their advantages and disadvantages

Now read on …

Read Session 3: GOVERNMENT EXPENDITURE AND FISCAL POLICY 

4.1 Sources of Government Revenue

Government income comes from a variety of sources, the main one being taxation. Other sources, which need only a brief mention here, are:

1. social security contributions;
2. surpluses (profits) of state enterprises and other state trading authorities paid over to the government;
3. rent, interest, and dividends earned by central and local governments;
4. sales of public assets (e.g. privatization proceeds);
5. direct charges to users of government services (e.g. the use of beds by private patients in state-run hospitals, charges for medicines provided by the state health system, etc.)

4.2 Uses of Tax Revenue

Taxation’s primary function is to generate revenue to finance government spending, but it can also be used to influence expenditure patterns, redistribute income and wealth, and reflect other social and political goals.

It is tempting to view taxation as a “evil” due to the fact that it can discourage companies from investing more capital when high-profit taxes reduce the potential returns to private investors and may discourage individuals from working and saving, possibly encouraging the growth of the so-called underground economy, in which individuals work for cash and do not declare their income for tax purposes.

4.3 Features of A Well Designed Tax System

In general terms, a tax system may be deemed well-designed if it is structured such that:

1. The amount of tax to be paid is easily understood by everyone so that uncertainty and consequent damage to the economy does not occur.
2. Payment is convenient (e.g. the ‘pay-as-you-earn’ (PAYE) system, which collects income tax on employees’ earnings from employers and before wages are paid to the employees)
3. The government’s tax collection costs are minimized a. similarly, compliance costs (costs to individuals and businesses of complying with the payment of taxes, e.g. collecting taxes on behalf of the government) should be kept as low as possible.
4. Tax rates can readily be adjusted up or down to reflect changing economic circumstances.
5. Work, investment, and enterprise are not greatly discouraged because of tax levels, otherwise, economic activity and tax revenues will suffer through disincentive effects.
6. Evasion and avoidance of the tax is difficult.

4.4 Types of Taxes

The numerous tax types collected by the government can be classified in a number of ways, including progressive, regressive, proportional, direct, and indirect.

We describe the characteristics as well as the benefits and drawbacks of each tax type individually.

4.4.1 Progressive Taxes

A progressive tax is one that takes a greater proportion of people’s income as their income rises. This is the type of income tax system used in most economies.

4.4.1.1 Advantages of Progressive Tax

1. Generally, progressive taxes facilitate redistribution of wealth from the better off to the poorer sections of society.
2. Also, a progressive income tax may help counterbalance the regressive nature of other taxes, which may bear more heavily on the less well-off.

4.4.1.2 Disadvantages

1. High and progressive taxation can act as a deterrent to investment and initiative in both the business and household sectors
2. It encourages tax evasion and the use of economic resources in inventing complex tax avoidance schemes.
3. Moreover, progressive taxation may encourage unsustainable growth in public spending, especially if in democracies the majority vote for more spending on health, education, etc., and attempt to place the resulting costs on the shoulders of a rich but declining minority.
4. It can also encourage a transfer of wealth to other countries as individuals and businesses attempt to avoid paying high tax rates. The result is the establishment of ‘tax havens’ overseas

4.4.2 Regressive Taxes

A regressive tax removes a larger share of the income from those with the least ability to pay. An example would be a tax on essential commodities and services, such as basic foodstuffs and housing, or taxes on household utilities (poorer households typically spend a greater proportion of their incomes on food, housing, and utilities). In contrast to the progressive tax, the regressive tax descends more heavily on higher income levels.

• Proportional taxes

Proportional taxes take a set proportion or percentage of income in tax.

For example, an income tax rate that is constant across different income levels is a proportional tax. .

Whether taxes are regressive, progressive or proportional, they can also be classified as direct or indirect taxes, depending on the method of payment.

• Direct taxes

Direct taxes are remitted directly to the tax collection agency by taxpayers or their representatives. In addition, even though social security contributions are not technically a tax, they are primarily collected directly from employees and employers. Income tax, profits tax (corporation tax), capital gains tax, and inheritance and wealth taxes are the primary types of direct taxes. Governments typically impose direct taxes in a progressive or proportional manner. Their primary advantages are the generally low collection costs relative to tax yield and the difficulty of evading their payment.

4.4.4.1 Advantages of Direct Tax

1. Direct taxes are potentially fair and equitable, in that they can be levied according to ability to pay
2. They also act, to some degree, as automatic stabilizers, in that the amount of tax revenue rises when national income is rising, thereby increasing the leakage effect from the circular flow of income and taking some inflationary ‘heat’ out of the economy.
3. Direct taxes are also less inflationary than indirect taxes since they are not levied on expenditure and therefore do not raise the price of goods and services directly.

4.4.4.2 Disadvantages

1. There is the possibility of a poverty trap and a fiscal drag effect, which is a disincentive to working.
2. It undoubtedly also encourages growth of activity in the underground (or shadow) economy.
3. Tax payments tend to rise in real terms as people’s and businesses’ incomes rise when tax-free allowances and tax thresholds (the level at which different marginal rates of tax come into effect) are not increased in line with the general rate of price inflation.

4.4.5  Indirect Taxes

In contrast, indirect taxes are typically regressive or proportional and are applied to expenditures or the value added to production.

The primary indirect tax is the value-added tax (VAT), which is effectively passed on to the consumer (at least partially) in the price of sold products and services.

Other indirect taxes include taxes on beverages and beers, as well as tariffs or import duties.

4.4.5.1 Advantages of indirect taxation

1. It is argued that indirect taxes are preferable to direct taxes, in that the consumer has the choice of not paying the tax (e.g. VAT) by simply not consuming the taxed good or service.
2. Indirect taxes can also be levied on particular types of goods and services at different rates in order to encourage use (e.g. the use of public transport) or to discourage consumption (e.g. cigarettes, petrol
3. Indirect taxation can be a flexible fiscal policy weapon because it may be possible for the rates to be altered quickly and with immediate effect.

4.4.5.2 Disadvantages of indirect taxation

1. It conceals the true tax burden that people face because they are hidden. By contrast, income and profits taxes are normally much more transparent to the payers.
2. Indirect taxes such as VAT also tend to have an inflationary impact on the economy.
3. Indirect taxes tend to be regressive in nature

In this session, we discussed taxation as a source of government income. We have learned that taxation could either be progressive, regressive or proportional.

Taxes could also be classified as direct or indirect, and all of these have their merits and demerits.

Self-Assessment Questions

Exercise 3.4

1. Governments raise revenue from many sources. Outline any five of them.
2. What are the features of a well-designed tax system?
3. Mention any three uses of tax revenue.
4. Differentiate between progressive and regressive tax
5. Explain proportional tax.
6. Using the advantages and disadvantages, explain direct and indirect taxes.
7. What are the advantages and disadvantages of the progressive tax system?

SESSION 3:

CONTINUE WITH SESSION 5: