4.5.2 Taxation

Incentive to work

• The higher the tax rate, the lower the incentive for the unemployed to seek work - or for existing workers to work overtime
• In 2022, the Adam Smith Institute calculated that average earners in the UK work from the 1st January to the 8th June (Freedom Day) to pay their taxes - all income after that point belongs to them

Tax revenues

• The Laffer curve illustrates the relationship between increasing tax rates & the level of government revenues received
• The broad idea is that as tax rates increase, a point will be reached where disincentivized workers work less resulting in less income & less government tax revenue. More people will actively seek to avoid paying tax (tax avoidance) or try to move their income elsewhere
  
  

The Laffer Curve demonstrates the relationship between tax revenue & tax rates

• Tax rate increases up to point A, will result in an increase of tax revenue.  Further tax rate increases from A to B result in a loss of tax revenue from C to D

Income distribution

• A progressive tax system redistributes from those with higher income to those with lower income & reduces income inequality
• Sometimes the benefits of a good progressive tax system are eradicated by the penalties imposed through multiple regressive (indirect) taxes

Real output & employment

• If the tax rate increases, more money is withdrawn from the circular flow of income (leakage)
• This will likely cause a reduction of aggregate demand (AD) as firms & households have less disposable income
• As AD slows down, fewer workers may be required for production & unemployment may increase

Average price level

• An increase in indirect taxes reduces disposable income & so workers may petition their employer for a salary increase
• If they receive the increase the economy may face a wage-price spiral
• Indirect taxes also increase costs of production for firms possibly leading to cost-push inflation

The trade balance (X-M)

• An increase in taxes can reduce disposable income which is likely to reduce the level of imports
• This may improve the trade balance (exports - imports)

Flows of Foreign Direct Investment (FDI)

• If the rate of corporation tax increases relative to other countries, it may result in less inward foreign direct investment