TAXATION

Differentiate between a direct and indirect tax:

Direct tax- Direct tax is the tax imposed on the income and wealth of individuals and firms. It
is usually progressive in nature. The impact (initial burden) and the incidence (final burden)
is on the same person. Tax burden cannot be transferred to anyone else. Examples of direct
tax include: Income tax, Wealth tax, Corporate tax, Inheritance tax, etc.
Indirect tax- Indirect tax is the tax imposed on expenditure on goods and services. It is
usually regressive in nature. The impact (initial burden) and the incidence (final burden) is on
different people. Tax burden can be transferred to anyone else. Example of indirect tax
include: GST, VAT, Service tax, Sales tax, etc.
What are the non-tax revenue sources? RISEF2D

● Rent- The government charges rent on government owned land, buildings, and
houses.
● Interest- Interest, dividend and profits are received by the government on the
investments that they make.
● Special assessment levy- When a person owns a property near a famous landmark, or
a busy area like an airport, or metro, the person is expected to pay some interest or
charge to the government for this.
● Escheats- It refers to the claim of the government on the property of a person who
dies without leaving behind any legal heir or will.
● Fees- This is charged by public authorities for rendering a service to the citizens. For
instance, when an individual wants to issue a passport or a driving license, he or she is
supposed to pay a fee to the authority.
● Fines and penalties- These are again paid by those who break rules or the law.
Example: breaking the traffic signal, not paying tax on time, etc.
● Donations and grants- This is the money received from other countries during times
of difficulties, or an economic breakdown in order for the country to survive.
Why does the government charge tax?

● Redistribution of income and wealth by using progressive taxation and giving the
poor benefits in the form of subsidies.
● To fund and provide public goods such as streetlight as no other private sector firm
would do it.
● To encourage the production and consumption of merit goods by using the tax
revenue to give subsidies to the producers.
 ● To discourage the production and consumption of demerit goods such as alcohol by
imposing higher tax rates which makes it more expensive.
● The tax revenue can be used as a means to provide transfer payments like
unemployment benefits, pensions, etc.
● Government imposes tax on the firms that generate negative externalities and external
costs such as pollution, damage of the environment, etc.
● Government can use the tax revenue in order to pay interest on any loan that is taken
from other lenders such as the IMF and the World Bank.
● To discourage the consumption of imported goods, by charging higher taxes, they
become more expensive for the consumers to buy. And this tax revenue can be used to
give subsidies to exporter and domestic firms to make their products internationally
competitive.
Advantages of direct tax:

● Helps in redistribution of income

● It is based on the ability to pay the tax

● Higher revenue yield for the government

● The certainty is high as people are meant to pay it

Disadvantages of direct tax:

● If too high, it can reduce worker incentives

● If too high, it will reduce enterprise incentives

● It can cause tax evasion where people would not pay tax on time or pay lesser tax

● Can discourage investments and savings in the economy

Advantages of indirect tax:

● They are cost effective

● Expand the tax base for the economy, which means that more people are paying the
tax
● Can be used to discourage the production and consumption of demerit goods

● They cannot be evaded

Disadvantages of indirect tax:

 ● They are inflationary in nature

● They are regressive, hence can affect the poor

● Revenues are less certain and less predictable

● Can encourage tax evasion through smuggling

● Harmful to ancillary industries if the tax on raw materials is too high

TAX BURDEN

● Using a demand and supply diagram, explain the impact of increase in indirect tax
on equilibrium price and equilibrium quantity.
Who will bear more tax burden (consumer or producer) for inelastic goods such as petrol,
cigarettes?
Who will bear more tax burden (consumer or producer) for elastic goods such as luxury
goods, products having many substitutes?
Q:- Impact of Taxation on various Stakeholders:-
a. Impact of Taxation on Workers
- Income Tax Reduces Take-Home Pay
Workers pay personal income tax on wages, lowering their disposable
income.
- Higher Tax Rates Reduce Purchasing Power
As tax increases, workers can afford fewer goods and services.
- Discourages Overtime and Promotion
High taxes may make extra work or higher-paying roles seem less rewarding.
- May Prevent Entry into Labour Force
Some individuals may avoid working if net income after tax is too low.
- Can Encourage Hard Work in Some Cases
Especially for workers with fixed financial commitments (e.g. mortgages).
- Fixed Work Hours Limit Flexibility
Many employees are under contracts and can't change work hours in response
to taxes.
b. Impact of Taxation on Firms

c. Impact of Taxation on the Government

 d. Impact of Taxation on the Economy

Q: Explain the characteristics (canons) of a good tax system.

● Certainty – A good tax system should be certain. People should be able to easily
calculate how much tax they are required to pay and when it is due. This reduces
confusion and ensures transparency.
● Convenience – The method and timing of tax payment should be easy and
convenient for taxpayers. For example, deducting income tax from salaries makes it
less burdensome.
● Equity – A good tax should be fair and based on the ability to pay. Those who earn
more should pay a higher amount of tax, ensuring that the burden is distributed justly.
● Economical – The cost of collecting the tax should be low compared to the revenue
it generates. A tax that requires high administrative costs reduces the efficiency of the
tax system.
 ● Flexibility – A good tax system should be adaptable to changing economic
conditions, such as inflation, boom, or recession. It should not be rigid and must be
capable of reform when needed.

Parts of Fiscal policy

A) Expansionary fiscal policy: To expand the economy (AD) (Boost Economic
growth / Resolve Recession ) by Reducing Tax and Increasing government
expenditure in the economy.
If a government wants to raise aggregate (total) demand in order to increase economic
growth and employment, it will increase its expenditure and/or cut taxation by lowering tax
rates, reducing the items taxed or raising tax thresholds. For example, a government may cut
income tax rates. This will raise people’s disposable income, which will enable them to spend
more. Higher consumption is also likely to raise investment. The higher aggregate demand, in
this case, causes economic growth. With more goods and services being produced,
employment is likely to rise.

Past paper Question & Ans

1. Explain what is meant by a regressive indirect tax. [4]

Up to 2 marks for the indirect element:

• an indirect tax is a tax on spending (1)

• paid indirectly by consumers to the government via producers/the burden can be shifted (1)
• example/an indirect tax may have the same rate for most goods and services (1)

Up to 2 marks for the regressive element:

• all people pay the same rate irrespective of their income/ability to pay (1)

• the poorer people, therefore, will pay a higher percentage of income in tax than the richer
people (1)

Note: to gain 4 marks there needs to be reference to the ‘higher percentage of income’ paid.

2. Discuss to what extent direct tax such as income tax can help in redistribution of
income and wealth [8]

Up to 4 marks on how it can affect the distribution of income:

• a direct tax is a tax on the income of people and firms (1)

• income tax is usually a progressive tax (1) this takes not just more of the income of the
rich (1) but also an increasing proportion of their income (1) reduces the gap between
the income of the rich and the poor (1)

• tax revenue raised may be used to help the poor (1) e.g. spending on housing,
education and health care (1) this may increase the earning potential of the poor (1)

Up to 4 marks for why the effect may be limited:

• will depend on how progressive the tax is (1) some countries operate flat taxes (1)

• will be influenced by the extent of tax avoidance (1) some of the rich may find ways of
not paying the tax (1)

• a high rate may discourage effort and enterprise (1) leading to lower output (1) higher
unemployment (1) greater poverty/more uneven distribution of income (1)

• it may be offset by the regressive nature of other taxes (1)

• other factors may change such as a lowering of the minimum wage (1) how this could
affect the distribution of income (1)