Using Taxation to Reduce Inequality & Poverty (HL IB Economics)

The Role of Taxation

• The main source of government revenue is taxation

• Taxation is used to redistribute income so as to reduce income inequality in a nation 

Types of taxes

• Direct taxes are taxes imposed on income and profits

  • They are paid directly to the government by the individual or firm 

  • E.g. Income tax, corporation tax, capital gains tax, national insurance contributions, inheritance tax
    

• Indirect taxes are imposed on spending

  • The less a consumer spends the less indirect tax they pay

  • Examples of indirect tax include Value Added Tax (19% VAT rate in the European Union in 2022), taxes on demerit goods such as excise duties on fuel or cigarettes 
    

Types of tax systems

• Tax systems can be classified as progressive, regressive or proportional

• Most countries have a mix of progressive (direct taxation) and regressive (indirect taxation) taxes in place 
  

An Explanation of tax Systems

System	Explanation	Diagram
Progressive	As income rises, a larger percentage of income is paid in tax (called the marginal tax rate) In the diagram, when personal income rises from Y1 to Y2, the tax rate rises from TR1 to TR2
Regressive	As income rises, a smaller percentage of income is paid in tax In the diagram, when personal income rises from Y1 to Y2, the tax rate falls from TR1 to TR2 All indirect taxes are regressive In the USA, Federal income tax is progressive but almost all State taxes are regressive (the bottom 20% of income earners pay as much as 6x the % of their income than the top 20%)
Proportional	As income rises, the same percentage of income is paid in tax In the diagram, when personal income rises from Y1 to Y2, the tax rate remains constant at 20% In 2022, Bolivia was using this system with a proportional tax rate of 13%

 
The link Between Taxation & the Reduction of Income Inequality & Poverty

Direct & Indirect tax rate Calculations

• Indirect tax rate calculations focus on calculating the taxes paid by consumers on expenditure

  • Indirect taxes usually have to be identified from a table, before the calculations are made
     

• Direct tax rate calculations usually focus on the calculation of marginal and average tax rates from a set of data provided

  • Marginal tax rates represent the amount of additional tax paid for every additional dollar earned as income

  • Marginal tax rates increase as income increases

  • Average tax rates are calculated using the following formula