Two Types of Tax Systems - Essay Example

Tax systems There are two types of tax systems that work simultaneously in an economy. These two systems are called direct and indirect taxation. Both of these systems have different effects on the economy in terms of an incentive or disincentive. Direct taxation is levied on the income of people. They pay directly in taxes out of the income they earn. Similarly, indirect taxation is not levied on people’s income. Instead, it is levied on the spending of people. They pay the taxes each time they make a purchase. Direct taxes cannot be avoided. Anything that is earned will have to be given to the national exchequer. Indirect taxation can be avoided by reducing the spending. Indirect taxation leads to substitution effects. Since people know that their effort will earn less than the actual amount they were getting before the tax is levied, they will think that leisure has become cheaper for them now. For example, if a consumer was earning $10 and no tax was being levied on his salary, then any leisure hour was costing him $10. Now after a 10% tax is levied on his salary, each leisure hour is costing him only $9. Hence, leisure has become cheaper for him. This will lead to the substitution effect as people would substitute labor for leisure. Direct taxation can be a disincentive to work and would leads to more people choosing leisure over labor. Similarly, when the tax is reduced, leisure hour becomes expensive and more people try to substitute leisure for work. Hence, tax reduction helps in motivating people to expend more effort to their work. (Brue & McConnell 2006) Indirect taxation leads to income effect. Income effect occurs when people find that they have surplus money and therefore their demand for goods and services increase. In case of no tax levied people after earning certain amount of income will start preferring leisure over work. Since indirect taxation increases the prices of goods and services people will have to work harder to keep up their standard of living and will have to earn more income to buy the same “basket” of goods that they were buying before and this will lead to more working hours in the economy. In this case, increase in taxation would result in increase in incentives for people to work hard and to expend more effort. ii) Regressive Taxation system is one where rich people pay lesser proportion of their income as tax than the poorer people. For example, a flat tax of $5 would make a higher proportion for someone earning $100/month than someone earning $200/month. For someone earning $100/month it would be 5%, whereas for the other guy it would be 2.5%. This kind of tax system is normally regressive and usually indirect taxation is regressive. On the other hand progressive system is one where rich people pay higher tax than the poor people. Income tax is usually progressive as it takes into account the income of people. Regressive taxation can be an incentive for people to work hard and earn more money, whereas as progressive systems can be a disincentive. (Sloman 2003) Since regressive system leads to same amount of tax in absolute terms for both rich and poor, any additional work or money earned by poor people would reduce their proportion of income as tax. This makes people work harder to nullify the effects of regressive tax. For example, if someone is earning $100 and he knows that he will have to pay $5 in taxes every time irrespective of his income. He would try to increase his income to $105 to nullify the effects of the tax. This increase in income for $100 to $105 will increase his disposable income after tax from $95 to $100. The person by earning more would be $5 richer. Hence, regressive tax system encourages increase in effort. People work harder to increase their disposable income to improve their standard of living. Progressive system can be a disincentive to work harder. Since, progressive tax increases with the additional income earned, many people would be put off from working harder as they will think that any increase in their income would be taxed and would go to the government. This can create a feeling where people would start preferring leisure over work. The disincentive nature of this tax is such that historical data shows that there is increase in GDP with removal of direct taxation (progressive tax). Many growing economies such as Dubai and other Middle Eastern countries are giving tax holidays and income tax incentives to people to document their income. This has shown encouraging results and it is positively correlated with the increase in GDP. Hence, one can conclude that progressive tax system is a disincentive to work whereas regressive tax system creates an incentive to work harder and work longer. (Lipsey & Chrystal 2003) b i) Keynesians propagate active fiscal control by the government to regulate the economy and to make sure that economic stability exists all the time. They believe that the governmental control is vital in the economy to make sure that the “forces of lassiez faire” neither overheats the economy, nor leads to cooling down of the main functions of the economy. In essence, Keynesians believe in the balancing of the economic system. They believe that any kind of disequilibrium in the economy is the signal that the economy is not working very well. There are several ways in which Keynesians use tax approaches to stimulate the demand in the economy. In periods of recession, Keynesian put focus on government spending. They believe that the government can stimulate demand in the economy by starting its development projects. These development projects can be in the form of building dams, bridges and roads. These projects would bolster the economy by creating unemployment and business opportunities for the investors. The investors would be encouraged to set up businesses in order to take advantage of governmental spending in the economy. This will create new jobs in the economy and people will have more disposable income to spend. They will spend this income in the economy creating multiplier effect and hence all of this spending would start a cycle and will also create the snowball effect. This would lead to economic recovery and possibly a boom. However, economic booms are discouraged in Keynesian economics because it is though that booms lead to recessions. (Salanie 2003) Booms are nothing but the overheating of the economy. Booms lead to inflation, unemployment and an economic bubble read to burst at any moment. Keynesians avoid economic booms by using effective tax systems. Keynesians raise taxes in the period when the economy is doing well to prevent overheating. They make sure that everything that is earned does not get into the economy and does not create a multiplier snowball. They hoard the “extra money” to use it in the recessionary periods. During the periods when the economy is doing well, the taxes charged by the government are high which results in reduced disposable income for the people. Hence, they spend less and this way Keynesians prevent an economic bubble and cool down the economic forces at work. Keynesians are not rigid and believe in expansionary and contractionary fiscal policies to balance-off the economy. Whenever there is need of pumping money into the economy, the tax rates go down and government spending peaks. And whenever there is a need of contractionary fiscal policy, tax rates increase and government spending in the economy comes down to balance the disequilibrium. These are tax approaches used by Keynesians to promulgate better and efficient economic policies. ii) Recent times show that even “the great Keynesian model” has limitation. There seemed to be an effective Keynesian being followed by the government but yet the 2008 financial crisis were shallower and more threatening than any previous economic crises. The system completely failed to heal the economies in the current economic crises. The biggest limitation of Keynesian model is that it is inefficient in controlling the booms. Booms lead to recessions, but there is no way or no plan given by the Keynesians to avoid economic peaks. Keynesian also fails to realize the political pressures in the economy. In times of elections and other times, the governments use inappropriate policies that hamper the working of the economy. In other words, political influences dominate the economy, but yet there is no weightage given to the political pressures of the government in economic control. Another problem with the Keynesian model is that it fails to realize the impact of corruption in the economy. The theoretical model might be “perfect”, but in practice there is always a hiccup in its implementations. This leads to recessions and other economic anomalies that are witnessed from time to time. Keynesian model is also utopian based. It is very difficult for government to pump money into the economy in recessionary phases, because the government also experiences recession. Similarly, in times of growth, there is always more money needed to be spent on infrastructure and hence the functioning of Keynesian model is not always perfect because of the economic conditions. c) High Speed Rail (HS2) is a system based on the Keynesian Model. It is a project which will increase the government spending in the times of recession to stimulate demand in the economy. However, it is very difficult to comment on its success. As discussed before, Keynesian model is too perfect to be followed in a real economy. There is corruption, political influence and government cash register that matters for the project to work as suggested by Keynesian economics. However, one thing that can be said about the project is that it is the step in the right direction by the policy makers. They have realized that it was the need of the time to pump money into the economy and therefore they came up with a project of public good. This project will change its nature as soon as the economy will come out of recession. The government can tax the travel of the people once the economy is in a better condition and can earn great deal of revenue from the project. This is in line with the Keynesian policy of using the fiscal controls to heal the economic ailments. (Topham 2012) On paper, the project looks very encourage and it looks like that it is going to solve the economic problems and will guide the economy towards economic growth. However as discussed above, several issues such as political influence and corruption may reduce the efficacy of the project. There can be “crowding-out” effect because of the corruption and the projected money that was forecasted to be pumped into the economy might be reduced as the corrupt politicians take their share from the money of the project. All in all, the success of the project and the economic growth targets can be achieved using the project given that the implementation of the project is in the right hands. There should be more economists that should be controlling this project than politicians or ad-hoc committees to make this project a success and a model for other struggling economies to follow. The work is tough and would require dedication and excellent team effort by the people who have to implement this project to make it a success. (Moffatt 2012) Works Cited Brue, S & McConnell, C 2006, Economics, McGraw-Hills, New York. Lipsey, A & Chrystal, M 2003, Economics, Oxford University Press, Oxford. Moffatt, M 2012, About.com, viewed 11 March 2012, < HYPERLINK "http://economics.about.com/cs/taxpolicy/a/taxing_growth.htm" http://economics.about.com/cs/taxpolicy/a/taxing_growth.htm >. Salanie, B 2003, Economics of Taxation, The MIT Press, Michigan. Sloman, J 2003, Economics, Prentice, New York. Topham, G 2012, HS2 high-speed rail link gets green light and 'green' tunnels, viewed 10 January 2012, < HYPERLINK "http://www.guardian.co.uk/uk/2012/jan/10/hs2-rail-link-green-light" http://www.guardian.co.uk/uk/2012/jan/10/hs2-rail-link-green-light >. Read More