A2 Economics Revision - Direct and Indirect Taxation

Decisions about which types of tax to use as a way of raising revenue raise questions about the roles and relative merits of the different UK taxes. Should we move further towards relying on indirect taxes or are direct taxes the best way of generating enough revenue to fund government spending and cutting the fiscal deficit.

* Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax.

* Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services

Here is a brief summary of some of the arguments for and against a switch towards indirect taxation

1. Changing the pattern of demand - indirect taxes provide a way of altering the pattern of consumer demand by varying relative prices and thereby affecting our spending decisions. For example higher duties on fuel or air passenger taxes might affect demand for different modes of transport.

2. Linked to the previous point, indirect taxes are often used and justified as an instrument in correcting for externalities and associated market failures – indirect taxes can be used as a means of making the polluter pay and “internalizing the external costs” of production and consumption.

3. Because taxes are levied on spending, indirect taxes are less likely to distort the choices that people have to between work and leisure and therefore have less of a negative effect on work incentives. If people keep more of what they earn, they may be more likely to work extra hours and this can have a positive effect on the supply-side of the economy. Indirect taxes leave people free to make a choice whereas direct taxes leave people with less of their gross income in their pockets.
4. All tax systems are often to avoidance and evasion but perhaps spending taxes are less easy to avoid; often people are unaware of how much in duty and other spending taxes they are paying. And indirect taxes provide an incentive to save.

On the other side of the coin

1. Many indirect taxes make the distribution of income more unequal because indirect taxes are more regressive than direct taxes. Good examples include the excise duties on cigarettes and energy together with the tax on national lottery tickets.

2. Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation expectations. Much depends on whether suppliers choose to pass on some or all of any increase in tax e.g. higher VAT.

3. If indirect taxes are too high – this creates an incentive to avoid taxes through “boot-legging” – e.g. the booze cruises to France where duty on alcohol and cigarettes is much lower.

4. Revenue from indirect taxes can be uncertain particularly when inflation is low (perhaps even a period of price deflation) or there is a recession causing a fall in consumer spending

5. From a microeconomics viewpoint, both specific and ad valorem taxes can lead to a loss of welfare e.g. loss of producer & consumer surplus. And higher indirect taxes affect households on lower incomes who are least able to save

6. Many people are unaware of how much they are paying in indirect taxes – they may be taxed by stealth – this goes against one of the basic principles of a tax system – that taxes should be transparent.

Value judgements
Ultimately one’s view about which type of tax system to use involves normative economics and often deeply-held value judgements. But given that the tax burden measured as a share of national income is set to rise in coming years as part of the strategy to reduce the government deficit, we all need to think about which taxes (old and new) are best as a way of raising revenue. Higher VAT appeared to be the elephant in the room during the 2010 General Election campaign. I am convinced that the standard rate of VAT will rise at some point to 20 per cent and/or that the exemptions to VAT will be altered. It is a big tax-raiser for the government and one that many might prefer on the grounds of the unavoidability of income tax and national insurance.