TAXATION CALCULATIONS

HL2 MACROECONOMICS

TYPES OF TAXES

There are many different types of taxes Including:• Direct Taxes• Indirect Taxes• Progressive Taxes• Regressive Taxes• Proportional Taxes

Direct Taxes

• Direct taxes are imposed on peoples’ income or wealth, and the profits of firms.

• The income from households comes in various forms such as employment income and interest on savings and dividends from the ownership of shares.

• Some of the income is taxed directly by employers, while some is charged based on the annual “tax return” form that people are usually obliged to fill out.

• Theoretically such taxes are unavoidable, because households and firms are obliged to declare their full income to governments and pay taxes accordingly.

Indirect Taxes or Expenditures Taxes or Consumption Based Taxes

• Indirect taxes are also known as expenditure taxes or consumption taxes and have different names in different countries.

• Canada and Australia have a “goods and services tax” (GST)

• The UK has a “value added tax” (VAT) and so does Austria (Mehrwertsteur)

• In this case, consumers who buy the goods pay the tax to the seller or producer who then pays the tax to the government.

Indirect Taxes or Expenditures Taxes or Consumption Based Taxes

• In a sense these taxes are avoidable, as consumers have the choice as to whether to buy the goods or not and in what quantities.

• Governments may vary the rate of indirect tax they charge on different goods and services, with necessity and valued goods such as food in supermarkets, being charged at a lower tax rate than luxuries, such as food in restaurants.

• Alternatively, they may treat all goods the same.

Direct Taxes and Indirect TaxesFurther Classification

There are three different categories into which we can place direct and indirect taxes. • Progressive Taxes• Regressive Taxes • Proportional Taxes

Progressive Taxes

• Many countries use a progressive tax as the main way to redistribute income from higher income earners to lower income earners.

• A progressive tax means that as incomes rise, people pay a higher proportion of this income in taxes.

• Usually there is a certain amount of income that is not taxed at all.

• However, when the income moves beyond the minimum, then a certain percentage of the income will have to be paid to the government.

• Then as income rises further, a progressive tax would take a larger percentage at higher incomes.

Progressive Income Tax ExampleTaxable Income % to be paid as tax

0 - $10,000 0

10,001-25,000 30

25,0001-50,000 40

50,001 and higher 50

If a person were to earn $15,000, then they would pay no taxes on the first $10,000 and 30% on the next $5000 so they would pay $1500 in taxes. This represents an average tax of 10%. As we can see from this table, the average tax rises as income rises, making it a progressive tax.

Tax Deductions

• It important to note that the previous example represents a very simplified tax structure.

• In reality most countries tax structures are infinitely more complicated.

• The biggest complication comes in the form of tax deductions and the calculation of taxable income.

• Tax deductions allow people to reduce their “taxable income” as result of spending of items that relate directly to their work.

Example of Tax Deductions

• For example, if a worker must travel a long distance to work and this costs $1000 a month, the government might allow the person to deduct this spending from her taxable income, thus reducing the amount of tax that she pays.

• The government might do this because it feels that this will encourage people to find work and lower unemployment.

• What is considered to be a tax deduction is different from country to country

Regressive Taxes

• A tax is known as a regressive tax if the proportion of income paid in tax (the average rate of tax) falls as income rises.

• Indirect taxes are regressive taxes. • GST or Sales taxe are regressive taxes.

Regressive Tax - Example

• Assume there is a $1.00 tax on every litre of petrol.• The average commuter spends about $50 per

month in petrol taxes.• For a person earning $500 per month, the tax will

take 10% of their income. • For a person earning $2500 per month, the tax will

represent 2% of their income. • The tax is regressive because a higher proportion

of income is paid at lower levels of income.

Regressive Taxes exacerbate income inequality

• Regressive Taxes may be a good source of government revenue and they might discourage the consumption of demerit goods, BUT THEY CAN WORSEN INCOME INEQUALITY.

Proportional Taxes

• A tax is proportional, if the proportion of income paid in tax is constant for all income levels.

• Many countries are now promoting the idea of proportional direct taxes or flat taxes, whereby the same percentage of tax is paid at all levels of income.

Reasons for Proportional Taxes

The Tax System is too complex• A glance at the tax guide for most countries

will confirm that taxation is an incredibly complicated process, with ample room for error and manipulation.

• This may result in governments earning less revenue than expected as people find ways to avoid paying taxes.

Reasons for Proportional Taxes

Direct Taxes are Disincentive to work Harder • It might be argued that high rates of taxes

discourage people from working harder, moving into higher paid jobs and taking risks. WHY? They will be reluctant to loose their own gains to higher taxes.

• If taxes were to be constant, then this could be viewed as a supply-side policy to encourage greater incentives to work and therefore raise labour supply.

REDISTRIBUTION OF INCOMETransfer Payments

• Governments can use tax revenues to redistribute income and provide different types of assistance to groups in the economy to improve their standards of living.

• These are known as transfer payments.• Transfer payments are not included as income in

national income accounting. This is because they do not represent payment for the production of a good or service. They are payments made to increase the income of particular groups within the economy.

REDISTRIBUTION OF INCOMETransfer Payments

Examples of Transfer Payments• Child support assistance, pensions,

unemployment benefits, payments to disable people and subsidies to producers.

REDISTRIBUTION OF INCOMEOther policies

• A minimum wage policy is designed to ensure that workers are paid what is determined to be a “fair” wage.

• Governments may also legislate that firms pay social security benefits such as a designated minimum amount to cover medical insurance and or pensions for their workers.

• Both of these serve to redistribute income from firms to workers.

• It could be said that government sponsored training schemes are a way of helping workers find gainful employment and thus raise their living standards.

EVALUATION OF REDISTRIBUTION OF INCOME POLICIES

• While many would argue that it is a government’s obligation to ensure that its citizens enjoy a “reasonable” standard of living, this is a problematic issue for many reasons, not the least of which is the question of what constitutes a reasonable standard!.

Neo Classical Perspective Redistribution of Income

• As to be expected, economists who support a classical point of view tend to argue against the active role of government in redistributing income. They believe it interferes with market forces and results in inefficiencies.

• The neo classical view argues that the optimal allocation of resources occurs in free markets and so government taxation must be kept to a minimum.

Neo Classical Perspective Redistribution of Income

• If firms have to pay insurance and social security costs for workers, then this will encourage firms to hire few workers, thus contributing to unemployment.

• High taxes in a country might discourage entrepreneurial activity and even encourage entrepreneurs to leave a country in search of more “favourable” tax climates.

Neo Classical Perspective Redistribution of Income

• High taxes have negative effects on overall growth in the economy due to the disincentive effect.

• Lower taxes will encourage economic activity leading to an overall increase in output that will be to the benefit of all people.

Taxes and the Neo Classical Perspective

• Economists promoting a free market view might argue that taxes should be used to finance the obligations of the government to ensure property rights, reduce the effects of market failure, provide effective security and judicial system and promote competition.

• However taxation should not be used to redistribute income.

Tax Calculations & HL Paper 3

• In HL Paper 3, you may be asked to calculate, from a set of data, the marginal rate of tax and the average rate of tax.

Sample HL Paper 3 QuestionTax Brackets for Country XYZ

Income ($) %

0-5,000 0

5001 to 20,000 20

20,000 - 40,000 40

40,000 50

Tax Formulas

AVERAGE TAX RATE: Total Tax PaidIncome x 100

MARGINAL TAX RATEChange in Total Tax PaidChange in Income x 100

Sample Tax Payers

• Individual A (low income) earns $15,000 per year.• Individual B (middle income) earns $38,000 per

year.• Individual C (high income) earns $90,000 per year.

1. Calculate the amount of income tax paid by individuals A, B & C as a percentage of income. Eg: their average tax rate.

Individual A (low income)$15,000 per year

• $5000 x 0% + 10,000 x 20% = $2,000 tax paid

Therefore average direct tax rate is $2000 / $15000 x 100 = 13.33%

Individual B (Middle Income)$38,000 per year

$5000 x 0% + $15,000 x 20% + $18,000 x 40% ($3,000) ($7,200) = $10,200 tax paid

Therefore the average direct tax rate is$10,200 / $38,000 x 100 = 26.84%

Individual C (High Income)Earns $90,000 per year

$5000 x 0% + 15,000 x 20% + 20,000 x 40%+ 50,000 x 50%.

= $3000 + $8000 + $25,000 = $36,000 (Total Tax Paid)

Therefore the average direct tax rate is $36,000/$90,000 x 100 = 40%

Marginal Tax RatesExample

• If individual B receives an increase in earnings from $38,000 to $48,000, what will be the marginal tax rate?

Individual B will now pay:$5000 x 0% + $15,000 x 20% + $20,000 x 40% + $8000 x 50%= $3000 + $8000 + $4000 = $15,000.Individual B is now paying $4800 in more tax.Marginal Tax Rate is ($4800 – change in tax paid) $10,000 change in income = 48%

Direct & Indirect Tax Calculations

Remember that if a person is paying direct and indirect taxes, then you could be asked to calculate: the average and marginal direct tax rates, the average and marginal indirect tax ratethe average & marginal total tax rates.

Exam Style Question

Tax Brackets for a Hypothetical Country

Income %0 - 10000 010001 to 30000 2030001 to 50000 4050001 + 50

Sample Tax Payers

• Individual A (low income) earns $20,000 per year and spends $14,000 on goods and services, of which 20% is indirect tax.

• Individual B (middle income) earns $45,000 per year and spends $30,000 on good and services, of which 20% is indirect tax.

• Individual C (high income) earns $120,000 per year and spends $80,000 on goods and services of which 20% is indirect tax.

Questions

1. Distinguish between direct & indirect taxes.2. Calculate the average direct tax rate paid by individuals A, B &

C.3. Use the data from the table to explain whether this type of

income tax system is progressive, regressive or proportional.4. Calculate the average indirect tax rate paid by individuals A, B

& C.5. Calculate the average rate of total tax (direct and indirect) paid

by individuals A, B & C.6. Individual B, receives an increase in income $45,000 to

$75,000. What will be the marginal tax rate?7. Explain why governments often employ progressive tax

systems.