The use and abuse of taxation

Public finance is the management of money collected through taxes by a local or national government. Tax is how the government raises money to spend on public services, such as education, health and the social security system. The primary function of taxation is to raise revenue to finance government spending (expenditure). If governments spend more than they levy or charge in taxes, they have to borrow money. There are two broad categories of taxes: direct taxes and indirect taxes. Direct taxes are collected by the government from the income of individuals and businesses. Individuals pay income taxes on their on their wages or salaries. People in full-time employment pay tax through the Pay as you earn (PAYE) system. In this system, the money owed to the taxman is deducted at source, so when we get our pay slip it will record how much tax has already been taken out. A capital gains tax (CGT) is a tax charged on capital gains, the profit made from the sale of stocks, bonds, precious metals and property. Not all countries implement a CGT, and most have different rates of taxation for individuals and corporations. CGT is usually levied at a much lower rate than income tax. A capital transfer tax is usually imposed on inherited money or property. This tax is also known as death duty in Britain, and other names for this tax are inheritance tax or estate tax. Companies pay corporation tax on their profits. Business profits are generally taxed twice: companies pay tax on their profits (income tax in US), and shareholders pay income tax on any dividends received from these profits. Companies and their employees also have to pay taxes called national insurance in Britain, which the government uses to finance social security spending such as: unemployment pay, sick pay, etc. Indirect taxes are levied on the production or sale of goods and services. They are included in the price paid by the final buyer. In most European countries, companies pay value-added tax (VAT), which is levied at each stage of production, based on the value added to the product at that stage. The whole amount is added to the final price paid by the consumer. The European Value Added Tax (EU VAT) is a value added tax encompassing member states in the European Union Value Added Tax Area. Joining in this is obligatory for member states of the EU. The EU VAT is a consumption tax which taxes the consumption of goods and services in the EU VAT area. In the US, there are sales taxes. These taxes are collected by retailers and levied on the retail price of goods. Governments also levy additional taxes on commodities like tobacco products, alcoholic drinks and petrol. These are known as excise taxes or excise duties. These taxes can be designed to persuade people not to smoke or drink alcohol, for example. Therefore, they are sometimes given derogatory term sin taxes (or repressive taxes). Excises differ from customs duties or customs tariffs. Custom duties are often charged on goods imported

from abroad, and therefore they represent border taxes. Excises, however, are inland taxes as they are charged on goods produced for sale, or sold, within the country. There is always a lot of discussion about the fairness of tax systems. Income tax for individuals is usually progressive: people with higher incomes pay a higher rate of tax than people with lower incomes. The problem with progressive taxes is that the marginal rate the tax people pay on any additional income- is always high. This is disincentive to both working and investing. However, indirect taxes are actually regressive, because poorer people need to spend a larger proportion of their income on consumption than the rich. Indirect taxes such as sales taxes and VAT are called proportional taxes, as they are imposed at a fix rate. The higher the tax rates, the more people are tempted to cheat. In order to reduce income tax liability (the amount of income tax that employees have to pay) some employers give their staff lots of perks (perquisites or perqs) or benefits instead of taxable money. These benefits include free health insurance, a company car, subsidised lunches, and so on. Legal ways of avoiding tax, such as these, are known as loopholes in tax laws. Using legal methods to minimize tax burden- the amount of tax one has to pay- is called tax avoidance. Life insurance policies, pension plans and other investments by which individuals can postpone the payment of tax are known as tax shelters. Donations to charities that can be subtracted from the income on which tax is calculated are described as tax-deductible. Using illegal methods-such as not declaring income, or reporting it inaccurately- is called tax evasion (or informally, tax dodge) and can lead to serious penalties. There are various ways for the companies to avoid tax on profits. They can bring forward capital expenditure (on new factories, machines, and so on) so that at the end of the year all the profits have been used up. This is known as making a tax loss. Another illegal method includes registering head offices of MNK in tax havens- small countries where income taxes for foreign companies are low. The examples are Monaco, the Bahamas, and the Cayman Islands.