Taxation: types and economic effects

Direct and indirect taxes

• Direct taxes are levied on income and wealth and paid directly to the government by the person or firm taxed: income tax, corporation tax, capital gains tax, inheritance tax, social security contributions.
• Indirect taxes are levied on spending and collected by sellers: value added tax (VAT) or sales tax, excise duties on fuel, tobacco and alcohol, tariffs.

Progressive, proportional and regressive

• Progressive: the proportion of income paid in tax (average rate) rises as income rises; the marginal rate is above the average rate. Example: income tax with rising bands.
• Proportional: the same percentage of income at all levels (a flat tax).
• Regressive: the proportion of income paid falls as income rises. Indirect taxes are usually regressive because poorer households spend a larger share of their income.

Average tax rate = total tax / income x 100. Marginal tax rate = tax on an extra unit of income.

A hypothetical progressive income tax

Effects of changing tax rates

• Incentives to work: higher income tax lowers the reward for work (substitution effect: work less) but people may work more to keep their income (income effect).
• Tax revenues and the Laffer curve: as the tax rate rises from 0%, revenue rises at first, reaches a maximum, then falls as high rates discourage work, encourage avoidance and evasion, and push activity abroad. Diagram in words: tax rate on the horizontal axis (0 to 100%), revenue on the vertical; an inverted U with revenue zero at 0% and at 100%. The rate that maximises revenue is unknown in practice.
• Income distribution: more progressive taxes reduce inequality.
• Real output and employment: tax cuts raise disposable income and AD (and may raise AS through incentives).
• The price level: higher indirect taxes raise prices directly (cost-push); lower taxes raise AD.
• The trade balance: lower income tax raises spending, including on imports.
• FDI flows: lower corporation tax attracts TNCs; countries compete with tax rates.

Worked example

Using the table, calculate the tax paid, average rate and marginal rate on an income of $60,000.

1. First 10,000 at 0% = 0
2. Next 30,000 at 20% = 6,000
3. Remaining 20,000 at 40% = 8,000
4. Total = $14,000; average = 14,000 / 60,000 = 23.3%

Answer: Tax $14,000; average rate 23.3%; marginal rate 40%

Check yourself

1. Using the lesson's tax bands, calculate the tax paid on an income of $35,000.
   Show answer

   $5000. 0 on the first 10,000; 20% of 25,000 = $5,000.

2. Using the lesson's tax bands, calculate the average tax rate on an income of $50,000.
   Show answer

   20 %. Tax = 6,000 + 0.4 x 10,000 = 10,000; average = 10,000 / 50,000 = 20%.

3. A household earning $20,000 spends $16,000, including sales tax charged at 10% of the pre-tax price. Calculate the sales tax paid as a percentage of income to 2 decimal places.
   Show answer

   7.27 %. Tax = 16,000 - 16,000 / 1.1 = 1454.55; as a % of income = 7.27%.

4. Which is a direct tax?
   • VAT
   • Excise duty on petrol
   • An import tariff
   • Corporation tax
   Show answer

   Corporation tax. Corporation tax is levied on company profits (income).

5. A tax is regressive when
   • everyone pays the same amount of money
   • the proportion of income paid in tax falls as income rises
   • the rich pay more money than the poor
   • the marginal rate exceeds the average rate
   Show answer

   the proportion of income paid in tax falls as income rises. Regressive refers to the share of income, not the amount.

6. Using Laffer curve analysis, explain why cutting a very high top rate of income tax might increase tax revenue.
   Show answer

   At very high rates, the economy is past the revenue-maximising point; a cut increases the incentive to work, reduces tax avoidance and evasion and keeps high earners in the country, so the tax base grows enough to raise revenue.. Beyond the peak, lower rates raise revenue.

7. Explain how a cut in corporation tax could affect FDI and the balance of payments.
   Show answer

   Lower corporation tax raises post-tax profits, attracting more inward FDI, which is a financial account inflow; but later profit repatriation is a primary income outflow on the current account.. Tax competition attracts TNCs.

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Sources

• Pearson Edexcel International Advanced Level in Economics specification (issue 2)

Last updated 8 November 2026. Spotted a mistake? Tell us.