Fiscal Policy - Direct and Indirect Taxes
This study note looks at the relative advantages and disadvantages of direct and indirect taxation
•Direct taxes – are paid directly to the government by the individual taxpayer – usually through “pay as you earn”. Tax liability cannot be passed onto someone else
•Indirect taxes – include VAT and duties. The supplier can pass on the burden of an indirect tax to the final consumer – depending on the price elasticity of demand and supply for the product.
Arguments For Using Indirect Taxation
| Arguments Against Using Indirect Taxation |
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Tax Competition between Nations
- Tax competition describes a process where a national government decides to use reforms to the tax system as a deliberate supply-side strategy aimed at attracting new capital investment and jobs into their economy.
- The issue has become important in the European Union because some countries including France and Germany complain that poorer countries are using tax competition as an incentive to attract inward investment, yet they are also net recipients of EU structural funds.
- If these countries can afford to lower business taxes, can they also afford not to do with the extra EU funding that helps to finance, for example, infrastructural spending required sustaining fast rates of economic growth?
The Laffer curve
- Created by the US supply-side economist Arthur Laffer, this curve explores a relationship between tax rates and tax revenue collected by governments
- It argues that as tax rates rise, total tax revenues grow at first but at a diminishing rate.
- There may be a tax burden which yields the highest tax revenues. Beyond this, further hikes in taxation serve only to lower revenues
- The Laffer curve has been used as a justification for cutting taxes on income and wealth - the argument being that improved incentives to work and create wealth will broaden the base of tax-paying businesses and individuals and also reduce the incentive to avoid and evade paying tax.
- A Keynesian view on the effects of tax reductions on government tax revenue is that lower direct taxes stimulate higher spending within the circular flow which itself boosts demand, output, profits and employment, all of which can drive tax revenues higher.
Government spending and taxation levels in different countries
- There are big variations in the scale and breadth of government spending between countries
- Some evidence for this is shown in the next table which draws on state spending and tax data for the year 2011. The data shows spending and taxes as a share of national income and gives an idea of the extent to which the size of the state varies
- Cuba’s state-dominated economy has a very high level of government spending; so too in the case of Scandinavian countries where the welfare system is extensive and generous – funded largely by a highly progressive income tax system
- In many lower income countries the scale of the state is smaller, not least because the ability to rely on a strong flow of direct and indirect tax revenues is limited by the structure of their economy.
|Tax burden |
(Total tax revenue, % of GDP (2011)
|Government expenditure as a % of GDP (2011)|