3.4.9 Role of taxation in reducing poverty, income and wealth inequalities Notes

1. Poverty, income and wealth inequalities are one of the most pressing issues in contemporary economics.
2. In order to deal with these issues, governments often need to intervene.
3. One of the most common ways for governments intervention to reduce poverty and income and wealth inequalities is through taxation.

Direct taxes

There are three main types of direct taxes:

1. Personal income taxes: taxes levied on an individual's income from factors of production (rent, wages, interests, profits).
2. Corporate income taxes: taxes imposed on a company's profits after deducting expenses and allowances.
3. Wealth taxes: taxes on the market value of an individual's assets, such as property, investments, and savings.

Progressive, regressive and proportional taxes

Taxes can be differentiated by the following characteristics:

1. Progressive taxes:
   1. The higher the income, the higher the proportion of income paid as tax will be.
   2. For example:
      1. If you make less that USD 50,000 a year, you pay 10% of income tax.
      2. If you make between USD 50,000 and USD 100,000 a year, you pay 20% of income tax.
      3. If you make more than USD 100,000, you pay 50% income tax.
2. Regressive taxes:
   1. As income increases, the proportion of income paid as tax lowers.
   2. For example:
      1. If you make less that USD 50,000 a year, you pay 50% of income tax.
      2. If you make between USD 50,000 and USD 100,000 a year, you pay 20% of income tax.
      3. If you make more than USD 100,000, you pay 10% income tax.
3. Proportional taxes:
   1. As income increases, the proportion of income paid as tax will stay constant.
   2. For example:
      1. If you make less that USD 50,000 a year, you pay 20% of income tax.
      2. If you make between USD 50,000 and USD 100,000 a year, you pay 20% of income tax.
      3. If you make more than USD 100,000, you pay 20% income tax.

Indirect taxes

1. Indirect taxes are levied on goods and services rather than on income or wealth.
2. Even though producers transfer indirect taxes to the government, they are typically paid by consumers through higher prices.
3. Common types include value-added tax (VAT), excise duties on specific goods (e.g., alcohol, tobacco), and customs duties on imported goods.

The regressive nature of indirect taxes

1. Indirect taxes are fixed, at a certain rate (20%, USD 2 per kg...) for a certain product.
2. As a result, to acquire that good, consumers with lower incomes have to pay a higher proportion of their income in indirect tax than consumers with higher incomes.
3. Therefore, indirect taxes are regressive, and worsen income distribution.

Calculating direct and indirect taxes(HL only)

Marginal and average tax rate

To understand how income taxes are calculated, we need to look at:

1. Average tax rate: found by dividing tax paid by total income
2. Marginal tax rate: found by dividing tax on the next dollar by the next dollar of income.

Income taxes in progressive tax systems

When calculating the total income tax paid in progressive tax systems, we calculate the tax paid on each income bracket. The example below illustrates how this is done:

After calculating the final tax paid on the total income, we can calculate the average tax rate by using the following formula:

$$\text{Average Tax Rate (ATR)} = \frac{\text{Total Tax Paid}}{\text{Total Income}} \times 100$$

Continuing with our example above:

$$\text{Average Tax Rate (ATR)} = \frac{\text{Total Tax Paid}}{\text{Total Income}} \times 100 = \frac{9500}{45000} \times 100 = 21.11\%$$

Calculations for indirect taxes

Lets say that after paying its income tax of 9500$, the disposable income left for the individual from our example above is:

$$45000\ \text{\$} - 9500\ \text{\$} = 35500\ \text{\$}$$

Let's say this person bought some goods and services that have an indirect tax of 12%. How do we find how much indirect tax this person paid?

Evaluating taxes as a method to redistribute income

Advantages of taxes

1. Taxes are effective for funding essential programs for lower-income groups:
   1. Tax revenues enable governments to fund crucial public services and welfare programs, such as:
      1. Healthcare: Ensuring access to affordable or free medical services improves the overall health and productivity of the population.
      2. Education: Public funding for schools and universities helps provide equal opportunities, allowing individuals from lower-income backgrounds to improve their skills and earning potential.
      3. Unemployment Benefits: Safety nets for those who are unemployed or underemployed prevent extreme financial hardship and support households during difficult times.
   2. Therefore, through funding public services and welfare programs, taxes play a vital role in supporting lower-income households and reducing poverty.
2. Breaking cycles of poverty:
   1. By funding these programs, taxes can help address systemic inequalities and create opportunities for social mobility.
   2. Improved access to essential services can enable individuals to escape poverty, contribute to the economy, and improve their overall quality of life.

Disadvantages of taxes

While taxes can reduce income disparities through redistribution, overly high tax rates on wealthier individuals or businesses can have negative consequences, such as:

1. Economic Inefficiencies:
   1. High taxes, especially in progressive systems, disincentivize individuals and businesses from maximising their income by expanding operations.
   2. This can potentially limit economic growth and productivity.
2. Reduced investments:
   1. Businesses and individuals may cut back on investments in innovation and infrastructure.
   2. This can harm long-term economic development.
3. Tax avoidance:
   1. High taxes may encourage tax avoidance strategies, such as offshoring income or exploiting loopholes.
   2. This can undermine the effectiveness of the tax systems and lead to unfair outcomes.