Taxation

19.12.2017

Episode #8 of the course Introduction to macroeconomics by Doha Soliman, CFA

Welcome back! Today, we’ll be continuing with our fiscal policy theme, particularly taxation policies. Let’s start with understanding taxes.

Governments generate revenue by imposing taxes. This means that government spending is financed mostly by tax revenue (less significant are debts, such as government bonds).

So, are taxes good or bad? It depends whom you ask. Governments like tax revenue because it allows them to spend more. More spending usually boosts the economy and thus, their approval goes up. However, consumers and businesses are generally opposed to tax increase, as it cuts into their disposable income and profits.

So, you might be wondering: Are all countries taxed in the same manner? The answer is not at all! Different countries have completely different tax systems and some even have no taxes! Let’s explore the three main types of tax systems.

Progressive Tax System

This tax system is the most common around the world. The tax rate goes up as a person’s income goes up. It’s usually divided in tax brackets.

For example: Individuals in the first tax bracket (\$0-50,000) pay no taxes. The second tax bracket (\$50,000-60,000) pays 15%. The third tax bracket (\$60,000-70,000) pays 20%. If you make \$65,000 per year, you’ll pay \$0 in taxes on the first \$50,000, 15% on the next \$10,000, and 20% on the last \$5,000 for a total of \$2,500.

Proportional Tax System

This tax system, also called a flat tax rate, is a system in which the same tax rate applies to all taxpayers, regardless of income. For instance, a government can levy a tax of 10% on all income earned, i.e. whether someone’s income is \$10,000 or \$10 million, the 10% rule applies.

Regressive Tax System

The final tax system we’ll introduce, the regressive tax system, is one in which the tax rate decreases as the income increases. It is the opposite of a progressive tax, which is described above.

In keeping up with the example I mentioned earlier, the tax brackets would be as follows:

income earned – (0-\$50,000) – tax rate 20%

income earned – (\$50,000-60,000) – tax rate 15%

income earned – (\$60,000-70,000) – tax rate 10%

So, for someone earning \$65,000 per year, they would end up paying (\$10,000 + \$1,500 + \$500 = \$12,000)

This type of system would favor individuals with high earnings. As income increases, the marginal tax (tax paid for every additional dollar earned) rate would thus decrease.

Taxes affect all components of an economy. As was shown by the tax systems above, the difference of taxes paid can vary greatly based on the tax system in place. This also applies to businesses, organizations, and governments. Since taxes play such a large role in most nations, they are highly intertwined with politics, and most politicians develop a stance on taxation in their platforms.