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The use and abuse of taxation

Public finance is the management of money collected through taxes by a local ornational government. Tax is how the government raises money to spend on publicservices, such as education, health and the social security system. The primaryfunction of taxation is to raise revenue to finance government spending

(expenditure). If governments spend more than they levy or charge in taxes, theyhave 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 andbusinesses. 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, sowhen 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 fromthe sale of stocks, bonds, precious metals and property. Not all countries implementa 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 taxis also known as death duty in Britain, and other names for this tax areinheritance tax or estate tax.

Companies pay corporation tax on their profits. Business profits are generallytaxed twice: companies pay tax on their profits (income tax in US), andshareholders pay income tax on any dividends received from these profits.Companies and their employees also have to pay taxes called national insurancein 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 areincluded in the price paid by the final buyer.In most European countries, companies pay value-added tax (VAT), which islevied at each stage of production, based on the value added to the product at thatstage. The whole amount is added to the final price paid by the consumer. TheEuropean Value Added Tax (EU VAT) is a value added tax encompassing memberstates in the European Union Value Added Tax Area. Joining in this is obligatory formember states of the EU. The EU VAT is a consumption tax which taxes theconsumption of goods and services in the EU VAT area.

In the US, there are sales taxes. These taxes are collected by retailers and leviedon the retail price of goods. Governments also levy additional taxes oncommodities like tobacco products, alcoholic drinks and petrol. These are known asexcise taxes or excise duties. These taxes can be designed to persuade peoplenot to smoke or drink alcohol, for example. Therefore, they are sometimes givenderogatory term sin taxes (or repressive taxes). Excises differ from customsduties or customs tariffs. Custom duties are often charged on goods imported

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from abroad, and therefore they represent border taxes. Excises, however, areinland taxes as they are charged on goods produced for sale, or sold, within thecountry.

There is always a lot of discussion about the fairness of tax systems. Income tax forindividuals 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 themarginal rate the tax people pay on any additional income- is always high. Thisis disincentive to both working and investing. However, indirect taxes are actuallyregressive, because poorer people need to spend a larger proportion of theirincome on consumption than the rich. Indirect taxes such as sales taxes and VATare 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 reduceincome tax liability (the amount of income tax that employees have to pay) someemployers give their staff lots ofperks (perquisites or perqs) or benefits insteadof 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- iscalled tax avoidance.Life insurance policies, pension plans and other investments by which individualscan postpone the payment of tax are known as tax shelters.Donations to charities that can be subtracted from the income on which tax iscalculated are described as tax-deductible.

Using illegal methods-such as not declaring income, or reporting it inaccurately- iscalled 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 capitalexpenditure (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 illegalmethod includes registering head offices of MNK in tax havens- small countrieswhere income taxes for foreign companies are low. The examples are Monaco, theBahamas, and the Cayman Islands.