Taxes and their effects

Direct and indirect taxes

A tax is a compulsory payment to the government. Taxes are classified by who pays them and how.

VAT is charged as a percentage of the price before tax. In Ireland the standard rate is 23%, and there are reduced rates such as 13.5% and 9%.

Why do governments like indirect taxes? They are easy to collect (the shop does the work) and hard to avoid. Why do they also use direct taxes? Because those can be tailored to a person's ability to pay.

Progressive, regressive and proportional taxes

Economists also ask: how does the tax burden change as income rises?

• Progressive tax: the tax takes a higher percentage of income as income rises. Example: Irish income tax, with a 20% band and a 40% band.

• Proportional tax: the tax takes the same percentage of income at all income levels. Example: a flat-rate tax on everybody's income.

• Regressive tax: the tax takes a lower percentage of income as income rises. Example: a flat charge or an indirect tax on a necessity such as a TV licence-style fee.

Why does this matter? A progressive tax reduces inequality, since higher earners give up a bigger share. A regressive tax hits low-income households hardest, even if every household pays the same amount.

Income tax: credits, average and marginal rates

Irish income tax has two rates applied to different slices of income. The first slice up to the standard rate cut-off point is taxed at the standard rate (20%); the rest is taxed at the higher rate (40%). Then tax credits are subtracted from the tax bill (not from income).

Three terms to know:

• Gross tax = tax calculated on income before credits.

• Tax payable = gross tax − tax credits.

• Average tax rate = $\dfrac{\text{tax payable}}{\text{gross income}} \times 100$. Marginal tax rate = the rate on the next extra euro earned.

Because the average rate is below the marginal rate and rises with income, this system is progressive. Credits make it even more so: they are a fixed amount, worth proportionally more to a low earner.

Who really pays? Tax incidence and deadweight loss

A tax on sellers raises their costs, so the supply curve shifts up (or left) by the amount of the tax. The new equilibrium has a higher price and a lower quantity. Tax incidence asks: who bears the burden?

• Consumers bear the rise in the price they pay.

• Producers bear the fall in the price they keep (price paid minus the tax).

Why is there a deadweight loss? Between 340 and 400 units, buyers valued the good by more than it cost to make, so those trades would have gained both sides. The tax stops them.

What decides the split? The more inelastic side bears more of the tax. If demand is inelastic (buyers need the good and cannot easily cut back), consumers cannot escape the higher price and bear most of it. If supply is inelastic, producers bear most. This is why governments tax goods with inelastic demand, such as tobacco, alcohol and petrol: the quantity falls little, so revenue is high and the deadweight loss is small.

Using taxes to correct market failure

Sometimes the market price leaves out a cost that falls on someone else: a negative externality. Social cost = private cost + external cost. The market then produces too much. A tax equal to the external cost makes the producer or consumer pay it, so the price reflects the full social cost. This is a corrective (Pigouvian) tax.

Why use a tax rather than a rule? Taxes also raise revenue, which the Government can use to cut other taxes or support households.

Carbon tax versus direct regulation

Incentives, labour supply and evaluating a tax cut

Taxes also change behaviour in the labour market. Income tax reduces take-home pay for each extra hour worked, so the return from working falls. In theory:

• A lower rate raises the net wage, so more people join the labour force and others work longer. Labour supply shifts right, and employment rises.

• But the effect can be small. People may work the same hours whatever the rate, and some may choose to work less once they earn the same take-home pay with fewer hours (an income effect).

A cut in the rate also changes Exchequer revenue and the distribution of income:

• Revenue falls on each euro earned, but if labour supply and reported income rise enough, revenue may fall by less, or even rise. This is the idea behind the Laffer curve: at very high rates, a cut can raise revenue. Few economists believe Irish rates are high enough for this.

• Cutting the top rate gives the biggest gain to high earners, so it widens inequality unless offset elsewhere.

When asked to evaluate, give points on both sides, use evidence or reasoning from the labour market, and reach a clear judgement.

Back to the start: tobacco is taxed heavily because demand is inelastic, so the Exchequer raises a lot of revenue, the quantity falls only a little, and the tax also tackles a market failure (health costs). Consumers bear most of the burden, and a share falls on producers.

Summary

• Direct taxes fall on income or wealth (income tax, USC, corporation tax). Indirect taxes fall on spending (VAT, excise duty).

• A tax is progressive, proportional or regressive according to how the percentage of income paid changes as income rises.

• Income tax payable = tax on each band − tax credits. Average rate = tax payable ÷ gross income. Marginal rate = rate on the next euro.

• A per-unit tax shifts supply up by the tax. Incidence is shared according to elasticity: the more inelastic side bears more. Revenue = tax × new quantity; deadweight loss = ½ × tax × fall in quantity.

• Corrective taxes (plastic bag levy, carbon tax, sugar tax) make people pay the external cost; they can be compared with regulation on efficiency, certainty, revenue, fairness and leakage.

• Tax cuts may change incentives and labour supply, but evaluate the effects on revenue and income distribution too.