SALIMAH MUSHARRIF Ch.

18 TAXATION

Ch. 18 TAXATION / FISCAL POLICY

WHAT IS A TAX?
Taxation is the government’s fiscal policy. It is an important source of revenue to
the government so it can spend on the public sector and provide social goods.

WHY DO GOVERNMENT’S TAX? / AIMS OF TAXATION / REASONS FOR

TAXATION
 Increase government revenue
 Raise prices of harmful goods to decrease their consumption
 To start social projects to increase employment
 To decrease income differences or reallocation of income and wealth via
progressive taxes [ social objective]
 To discourage imports.
 To decrease income in people’s hands by increasing taxes to decrease
inflation [ economic objective]
 To internalizes external costs which means taxing social costs such as
pollution to increase welfare. These are also referred to as the Pigouvian
taxes or welfare taxes.

WHAT IS A GOOD TAX?

These are also known as canons of taxation’s or principles for a fair tax.
The first four principles were given by Adam Smith an economist who wrote” the
wealth of nations” in 1776
1. Cannon of the equality: pay tax according to ability
2. Cannon of certainty:: how much tax to pay and when
3. Cannon of convenience
4. Economical the cost of collecting the tax should not be greater than the
tax earned

Later more principles were added.

5. Fairness
6. Must not discourage people from working: if tax is too high people may not
work
7. Flexible: easily adjust to changes or increase or decrease rate
8. Consistent with government policy:

TAX SYSTEMS
There are three types of tax systems
i) Progressive: the proportion of income taken in tax rises as income
rises. Or the higher the income, the higher the tax. The rich pay more
taxes than the poor.
ii) Regressive: as income increases the % of tax decreases. It is
considered unfair as the high income groups pay the least
iii) Proportionate: no matter what the income level is, the same
percentage of tax applies.

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PROGRESSIVE REGRESSIVE PROPORTIONAL

INCOME IN % TAX $ TAX % TAX $ TAX % TAX $ TAX
$ PAID PAID PAID
20,000 20 4,000 50 10000 10 2000
50,000 40 20,000 40 20000 10 5000
80,000 60 48000 30 24000 10 8000

% TAX

A = Progressive
B = Regressive
B C = Proportional

INCOME

ASSIGNMENT

TAX SYSTEM 1 TAX SYSTEM 2 TAX SYSTEM 3

INCOME TAX % INCOME TAX % INCOME TAX %
IN $ PAID TAX IN $ PAID TAX IN $ PAID TAX
5000 1500 10000 1000 8000 3200
15000 4500 16000 2400 12000 3600
25000 7500 30000 6600 20000 4000

TYPES OF TAXES

Direct tax
Direct tax is a tax taken directly from income or wealth and it is generally
progressive, such as an income tax, which decreases income.

Indirect tax
This is the tax on spending. It decreases consumption as it results in increased
prices. People pay the tax when they purchase the commodity.

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Types of direct taxes

 Income tax: a percentage payable or deducted from the income by the

employer. This amount is payable after a certain amount of income level is
attained
 If this is a tax on the company’s profit. It is charged on income from home
or abroad after expenses like interest on loans etc are paid.
 Capital gains tax: this is charged on an increase in the value of share
prices between the time they are purchased and sold. Private homes,
cars, incomes from gambling etc are exempt from this tax.
 Inheritance tax: it is a tax on the transfer of wealth above a certain limit at
the time of death. It is a proportionate tax.
 Property tax

Types of indirect taxes

Indirect taxes have a regressive effect because it takes a greater portion of the
poor person’s income
 Value added tax: This is a tax charged on the value added to output. Each
producer only pays V.A.T on the value he adds. Certain goods are either
“exempt” from this tax or “zero rated” Example of exempted goods are
land, rent, insurance, postage, betting and gaming finance, education,
health, burial services Etcetera. However VAT already paid cannot be
reclaimed as it can be under zero rating. Zero rating is on exports,, food,
children’s clothes, footwear, books, newspapers, drugs, medicines etc.

Important: Thus as a V.A.T. is not levied on exports and any VAT can be
reclaimed it is an incentive for exporters to produce.

Customs duties: goods imported from the same trading bloc are not taxed. Those
out of the bloc are taxed to discourage foreign competition
Excise duties: these are taxes levied mainly on volume, the main sources being
tobacco, alcoholic drinks and hydrocarbon oil that is petrol and diesel.
Tariffs: this is a protective duty on imports
Other taxes: motor car, road tax, heavy Vehicle Tax Etcetera

Advantages of direct tax

i) Revenue: the revenue is greater than the cost of collection example

income and corporation tax
ii) Redistribution : a direct tax is a progressive tax ensuring that taxes
paid by rich are greater than those paid by the poor
iii) Ability to pay: accounts of people, number of dependents etc are
taken into consideration before tax being levied

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iv) Important to government policy: if inflation in the economy increases

the direct tax can be increased so that incomes and consumer
demands decrease

Disadvantages of direct tax

i) Work disincentives: when people know that a greater portion of their

incomes will be taken away in tax they do not have an incentive to
work. So savings and investment also decrease
ii) Enterprise: a low corporation tax is an incentive for businessmen to
invest and expand as a high tax leaves produces with lower profits to
reinvest
iii) Tax evasion: high taxes lead to tax evasion and people finding
loopholes in tax laws. So the revenues gained are spent on trying to
catch evaders which increases costs
iv) No choice but to pay tax: the tax is not evadable if a person comes
under a certain income slab

Advantages of indirect taxation

i) Low Cost of collection: The cost of collection is low as the burden of

collecting the tax basically lies with the manufacturers and
wholesalers.
ii) Wider tax base: more people end up paying this tax as whoever buys
a good will have to pay for it.
iii) Selective aims: some products such as Cigarettes can be taxed to
decrease their consumption or to decrease demand for non renewable
resources
iv) Tax alterations the tax may be increased or decreased as necessary.
Thus it is flexible unlike direct taxes
v) Raising revenue: it is a good way to raise revenue from goods with an
inelastic demand
vi) Foreigners pay tax also: when foreigners purchasing a product that
has been taxed they end up paying the tax as well
vii) Evading this tax: The only way one can evade the tax is by not
buying that product

Disadvantages of indirect taxation

i) Regressive: a major disadvantage of an indirect tax is that it is
regressive, which means that the poor end up paying a greater
percentage of their income when buying the product than the rich
ii) Increases prices: as indirect taxes increase, prices increase and
hence inflation increases.
iii) Uncertainty : It can only be estimated how much people will spend on
commodities and so it cannot be accurately calculated how much
revenue the tax will raise

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iv) It is impartial: incomes targets certain groups such as drivers,

smokers Etcetera

EFFECTS OF TAXATION / RESULTS OF TAXATION

i) Incomes:
A high and direct tax decreases incomes which decreases demand, where as a
high indirect tax increases price so that incomes decrease and the standard of
living is adversely affected
ii) Savings and investment:
A higher tax decreases savings and investment
iii) Prices:
A high direct tax decreases incomes, demand, so inflation decreases or deflation
occurs. An indirect tax, however , raises the price.
iv) Effort:
A higher tax results in a disincentive to work
v) Economy:
A high tax results in a low demand so that production decreases, imports
decrease, the balance of payments improves, but unemployment increases as
less is demanded in the economy
vi) Consumption:
If the standard of living is low and savings are being cut down, an indirect tax
decreases consumption. If savings are high, however, it has little effect as people
can pay out of the savings
vii) Incentives:
As taxes are levied on individuals and corporations, disincentive sets in.
However, this is only after a certain level has passed.

Disincentives can be understood using the Laffer curve

B
TAX REVENUE

A
C

TAX RATE

A … Tax % Revenue People work more

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B… After point B as tax rate disincentive to work sets in and revenue

decreases

After a certain level of tax, an increase in the tax rate may force the individual to
work more hours to maintain their standard of living and so.
The higher the tax rate, the less the disposable income so that savings will be
reduced. For a corporation similarly, high taxes will leave less profit and so there
are fewer incentives to invest and expand especially for risky projects.

THE BUDGET
The budget is a document which shows government spending and revenue or
fiscal policy with revenue being generated from taxation and expenditure on
government social projects. Since the amounts of spending and taxation are very
great they can influence inflation, employment, output and, therefore, growth in
an economy.
Budget deficit: this is the situation when expenditures are greater than
revenues. A government may set out a deficit budget in order to increase
aggregate demand and therefore production and employment in an economy.
This should increase growth. The deficit is financed by the sale of securities on
which interest has to be paid. So as spending on the public is high and so is the
interest paid to the people, inflation increases. A deficit budget may also be
planned if economic activity slows down. It is in fact usually during a slump that
a deficit budget is made.
Budget surplus : is when government revenue is greater than government
expenditure. This has a deflationary effect as aggregate demand is low and
people have less money in hand. This decreases prices so that unemployment
may increase as production will decrease. A surplus budget is usually made
when an economy is in the boom.
Balanced budget: is one where expenditures equal revenue. It is very difficult to
prepare and it results in neither an inflationary or deflationary pressure.

GDP
A. Growth
B. Boom
C. Recession
D. Slump

Years

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ADVANTAGES OF FISCAL POLICY

 Fiscal policy may be used to change the allocation of resources
industrially and regionally by taxing some and subsidizing others
 It may protect some regions by means of tariff
 It may encourage investment by giving preferential tax treatment
especially if it wants to increase growth in some areas.

DISADVANTAGES OF FISCAL POLICY

 It is inflexible because there are too many calculations involved in
changing taxes especially income tax.
 A change in public spending is difficult because long term projects are
involved
 There is a long time lag between problems are occurring in an economy
and the remedial fiscal measure taking effect.

Assignments

 Differentiate between direct and indirect taxes

 Why do government’s tax?
 How the tax incentives for businesses?
 Calculation and identification of different types of taxes.

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