Theory and Practice of Taxation - Coursework Example

Topic: Lecturer: Presentation: Word Count: 1470 Introduction A government has an obligation of providing essential services to its people in order to improve their lives. One way to fulfil this obligation is by imposing compulsory levy from households and businesses. These levies are in terms of direct and indirect taxes. Direct taxes are imposed directly on person or corporation whereas indirect taxes are levied through a third party (Rolfe, 2008). Besides being a source of government revenue to promote social and economic welfare, taxation is used as a means of redistributing income and wealth from the rich members of society to the poor. Taxation is also used to enhance economic stability and control the producers hence protect the consumers from unfair practices. Direct taxes are considered fair as opposed to indirect taxes since they take into account the taxpayers circumstances but every tax system is guided by principles that determine whether a tax system is good or not. Principles of a Good Taxation System The principles of a good taxation system were developed by Adam Smith in 1776 and continue to be used in the modern taxation systems (Riley, 2006). Equity is one of the guiding principles in designing a tax system. A tax should be based on one’s ability to pay so as to exercise fairness. In this regard, direct taxes serve the purpose because as income increases, one pays more tax as a percentage of income hence the rich pay more taxes than the poor. On the other hand, indirect taxes are paid on final goods and are applied uniformly to all whether rich or poor. They don’t take into account one’s ability to pay thus creating inequality in society. A good taxation system should be certain (Rolfe, 2008). It should be clear as to what amount the tax payer is supposed to pay and when the amount is due so that they can plan ahead and avoid evading tax. Tax payers should also understand how the system works. Through direct taxes such as income and corporation tax, tax payers are aware of what they are expected to pay and when the amount is due hence they are certain and can plan for their incomes ahead. Besides, the tax rate is set once on a budget day creating certainty among tax payers. Indirect taxes on the other hand are uncertain and lack transparency as taxpayers are unaware of how much they are supposed to pay hence have no place in society. The government can raise indirect taxes such as the fuel duty, tobacco and alcohol duties at any time and this affects the society economically through increased prices. According to Nightingale (2002), a good taxation system should be efficient to administer without causing economic distortions. The cost of collection should be minimised relative to the revenue gained if efficiency is to be achieved. Although the administrative cost of indirect taxes is lower than direct taxes and direct taxes are seen as a disincentive to workers, no proof has yet been given regarding the issue. Increasing direct taxes may not necessarily mean that workers will not work harder to earn more income thus reduced quality of workforce. There are many factors that motivate workers and all workers strive to get promotion and a higher income despite the income tax. On the other hand, indirect taxes distort the economy by creating inflationary pressures (Rolfe, 2008). This makes consumers especially the poor to bear heavy tax burdens and their incomes are reduced hence have limited choices. Their well being is thus affected and hence indirect taxes are inappropriate. It also acts as incentive to avoid taxes as consumers avoid buying the goods such as cigarettes leading to loss in revenue which can be used to provide other essential services such as health and education. Flexibility is another principle of a good tax system. The taxation system should be easy to change to allow for any changes in the economy or free market. Direct taxes are not easy to change as they are set once in the budget. The rate of income tax hence remains the same until the next budget day. Indirect taxes are very flexible are mostly used to deal with externalities. Due to their flexibility, they affect the welfare of the society greatly. The prices of goods and services keep changing with change in indirect taxes and most producers pass the entire tax burden to the buyer especially for goods with inelastic demand such as alcohol and cigarettes (Nightingale, 2002). This leads to reduced consumption and later a reduction in production and output leading to unemployment which has a direct impact on the welfare of society. Direct taxes in this case are fair to the society as revenue raised is steady to improve their welfare unlike the indirect taxes which keep changing leading to loss in revenue for government and the society. Types of Taxes There are various types of taxes applicable in the UK. The direct taxes which are levied on individuals and corporations include; income tax, corporation tax, capital gain tax, and inheritance tax. The indirect taxes include; value added tax (VAT) and excise duties. The income tax which is deducted from employee salaries is referred as the pay as you earn (PAYE) tax system. It is paid as a percentage of taxable income after deducting the non-taxable allowances and personal allowance and ranges from 10% -40% depending on the income (Nightingale, 2002). Married couples are also given a tax relief. The income taxed is from employment, pensions, dividends, rental income among others. The non-taxable benefits include; working tax credit, child tax, maternity allowance, housing benefit, and premium bonds among others. The income tax therefore takes care of tax payers’ circumstance such as family size and level of investment and thus is fair. As income increases, the rate of tax increases hence the rich pay more tax than the poor as percentage of their incomes. The excise duties are indirect taxes levied on goods and services for revenue and to discourage consumption of certain goods hence they are selective in nature (Cnossen, 2005). The excise duty is levied on tobacco, alcohol and petrol so as to limit consumption. It is levied on the volume of the goods being taxed and hence duty is the same despite the amount consumed hence creating inequality. The duty is aimed at promoting a healthy society but it may be a disadvantage as it limits consumption hence reduced taxes and revenue for providing other services. The demand for the products is also inelastic hence the producers can pass the tax burden to consumers thus reducing their incomes and purchasing power. The value added tax is levied on final goods and services and is collected by the seller on behalf of the government. It is a constant value of 17.5% hence it’s a proportional form of taxation, tax increases with increase in income but the percentage of income remains constant (Anderton, 2000). It is paid uniformly for all goods hence the poor are overburdened with tax unless they reduce consumption of various goods. The government though tries to correct the imbalance by zero rating essential goods hence improving the welfare of society. Despite that, the tax creates inequality in society between the rich and the poor hence it isn’t fair. The corporation tax is another major source of revenue for the government. It is levied on UK firms’ profits. Larger companies pay a higher rate of tax than small firms hence taking into account the principle of fairness and equality (Lipsey & Chrystal, 2007). Why Government Raises Taxes Rolfe (2008) stresses the need for government to raise taxes in order to able to provide the society with essential services such as education, health, pensions and unemployment benefits among others. One way to ensure welfare of society is by distributing the income from the wealthy to the poor through income and corporation taxes. Indirect taxes only deteriorate the welfare of the poor in society. Government also raises taxes in order to control aggregate demand. By increasing direct taxes, the firms and households have less disposable income hence consume less thus removing excess demand from the economy. Raising indirect taxes especially through excise duties also improves the societies well being by reducing consumption of unhealthy products hence it has a small part to play in society. Conclusion Direct taxes are a way of enhancing equality in society by redistributing income from the wealthy to the poor. They are progressive in nature and hence are a fair means of taxation by treating similar situations equally and unequal situations unequally. They also take care of individual circumstances like family size and the insurance contributions are of help to society. However, we cannot ignore the role played by indirect taxes in ensuring a healthy society and correcting market failures that could deter economic growth. References Anderton, A. 2000. Economics 3ed. UK: Pearson Education Ltd. Cnossen, S. (Ed). 2005. Theory and Practice of Excise Taxation: Smoking, Drinking, Gambling, Polluting and Driving. US: Oxford University Press. Lipsey, R., Chrystal, K. 2007. Economics 11ed. New York: Oxford University Press. Nightingale, K. 2002. Taxation: Theory and Practice 4ed. England: Prentice Hall. Riley, G. 2006. “Macroeconomics: Direct and Indirect Taxation”. 27 October, 2010. tutor2u. http://tutor2u.net/economic/revision-notes/a2-macro-direct-indirect-taxation.html Rolfe, T. 2008. Financial Accounting and Tax Principles. UK: Elsevier. Read More