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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 Taxes
Further 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 Example
Taxable 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 INCOME
Transfer 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 INCOME
Transfer Payments
Examples of Transfer Payments
• Child support assistance, pensions,
unemployment benefits, payments to disable
people and subsidies to producers.
REDISTRIBUTION OF INCOME
Other 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 Question
Tax 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 Paid
Income
x 100
MARGINAL TAX RATE
Change in Total Tax Paid
Change 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 Rates
Example
• 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 rate
the average & marginal total tax rates.
Exam Style Question
Tax Brackets for a Hypothetical Country
($45,000 example
Income
0 - 10000
10001 to 30000
30001 to 50000
50001 +
%
0 (First 10,000 0%)
20 (20,000 X 20%)
40 (15,000 x 40%)
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.