Study Notes
Taxation is a key tool used by governments to finance expenditure, correct market failures, manage the macroeconomy, and redistribute income.
- Direct Taxes — taxes imposed directly on individuals or companies. Example: Income tax on individual earnings.
- Indirect Taxes — taxes imposed on goods or services. Example: Value-added tax (VAT) on consumer products.
- Progressive Tax — a tax where the proportion of income paid increases with higher income. Example: Income tax with higher rates for higher income levels.
- Regressive Tax — a tax where the proportion of income paid decreases as income rises. Example: VAT, as it takes a larger share of income from low-income households.
- Proportional Tax — a tax that maintains a consistent proportion of income paid regardless of income level. Example: A flat tax rate applied uniformly across all income levels.
Exam Tips
Key Definitions to Remember
- Direct Taxes
- Indirect Taxes
- Progressive Tax
- Regressive Tax
- Proportional Tax
Common Confusions
- Confusing direct taxes with indirect taxes
- Misunderstanding the impact of progressive vs. regressive taxes on income distribution
Typical Exam Questions
- If the tax system becomes more regressive, what effect will this have on income distribution? It will likely widen income disparities.
- Using the income and substitution effect, outline the view that a fall in income tax rates will increase incentives to work. Lower income tax rates increase disposable income, encouraging more work effort.
- How does a progressive tax differ from a regressive tax? A progressive tax increases with income, while a regressive tax decreases as income rises.
What Examiners Usually Test
- Understanding of different types of taxes and their economic effects
- Ability to analyze the impact of tax changes on income distribution and economic activity