3.4.3 Using Taxation to Reduce Inequality & Poverty

The main source of government revenue is taxation
Taxation is used to redistribute income so as to reduce income inequality in a nation

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

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
In the diagram, when personal income rises from Y₁ to Y2, the tax rate rises from TR₁ to TR₂

4-3-2-progressive-tax

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%)

4-3-2-regressive-tax

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%

4-3-2-proportional-tax

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

Progressive taxation

A progressive tax system redistributes from those with higher income to those with lower income and reduces income inequality
Redistribution often starts with the provision of free education and healthcare
Many governments use tax revenues to provide multiple levels of financial support to poor households including disability payments, heating subsidies, travel subsidies etc.
Sometimes the benefits of a good progressive tax system are eradicated by the penalties imposed through multiple regressive (indirect) taxes

Higher redistribution → better education/healthcare → better human capital → better productivity → higher income

SL IB Economics

3.4.3 Using Taxation to Reduce Inequality & Poverty