Government Revenue, Spending and Direct/Indirect Taxation

Two questions about the same tax

A government has to raise money before it can spend any, and this part of the course is about both halves of that: where the money comes from, and where it goes. Most of it comes from taxation, and taxes are where the interesting thinking is, because every tax gets described twice over, and the two descriptions answer completely different questions. The first question is how the tax is collected. A direct tax is charged on income or wealth and paid straight to the government by the person or firm it is charged on. An indirect tax is charged on spending, and is paid through the price of something, so it reaches the government by way of the seller. The second question is who the tax falls on hardest. A progressive tax takes a larger share of income from those with higher incomes. A regressive tax takes a larger share from those with lower incomes. Here is the thing to hold on to: those two questions are independent. Knowing how a tax is collected does not tell you who it presses on most, and the two are constantly confused. And the reason it matters is not a definition but a consequence, which this module builds towards: a tax on spending tends to be regressive, and nobody has to intend that for it to happen.

Words for raising and spending

Six terms. Read the middle four as two separate pairs, because that is exactly the distinction students lose.

Match the tax idea to its meaning

How is this one collected

A tax is added to the price of goods in a shop, collected by the seller and passed on to the government. How is it classified?

• An indirect tax, because it is charged on spending and reaches the government through the price rather than being paid directly by the person charged
• A direct tax, because the shopper definitely pays it
• A regressive tax, because it is charged on spending
• A progressive tax, because everyone pays the same rate

The two axes are independent

This is where the marks are, and it is worth being very deliberate about it. Direct and indirect describe the ROUTE the money takes to the government. Charged on income or wealth and paid straight over, or charged on spending and collected through the price of something. Progressive and regressive describe the SHARE OF INCOME the tax takes from different people. Larger from higher earners, or larger from lower earners. Neither answer tells you the other. A tax can be direct and progressive, if it is charged on income and takes a greater proportion as income rises. A tax can be direct and yet not progressive, if it is charged on income at a single flat rate. And a tax charged on spending is indirect however it happens to fall. So when a question asks you to classify a tax, ask which question it is asking. Students lose marks by answering "it is regressive" when the question asked how it is collected, or "it is indirect" when the question asked who it falls on hardest. Both answers may be true; only one of them was asked for. The most common real-world pattern, and the one to be able to explain, is a tax that is indirect and regressive. That combination is so frequent that students start to think the words mean the same thing, and the next few steps show exactly why they do not, and why the pattern arises anyway.

Which two are true of indirect taxes

Select the TWO accurate statements about indirect taxes.

• They are charged on spending and reach the government through the price of goods and services
• They tend to take a larger share of a low income than of a high one
• They are always deliberately designed to fall hardest on those with least
• They are charged on income and wealth

Work out the share of income

Using invented figures for illustration: a tax of 20% is charged on spending. Someone with an income of 20,000 spends 16,000 of it, so pays 3,200 in tax. What percentage of their income is that? Give the number only.

Where it comes from, where it goes

The two halves of the government's accounts. Your specification asks for the main areas of each rather than for exact figures, so learn the categories.

Revenue and spending in words

The money a government receives is its _____, most of which comes from taxation. A tax charged on income or wealth and paid straight to the government is a _____ tax, while one charged on spending and collected through prices is an _____ tax. A tax taking a larger share of income from higher earners is _____, and one taking a larger share from lower earners is _____. Those two pairs answer different questions and must not be confused.

Why a spending tax hits harder

This is the explanation that turns a definition into an answer, and the figures below are invented purely to show the mechanism. Suppose a tax of 20% is charged on everything people spend. The rate is identical for everybody, so at first glance it looks perfectly even. Now follow two people. Someone with an income of 20,000 spends 16,000 of it, because most of a small income has to go on necessities. They pay 20% of 16,000, which is 3,200. As a share of their income, that is 3,200 out of 20,000, or 16%. Someone with an income of 60,000 spends 24,000 of it, saving the rest. They pay 20% of 24,000, which is 4,800. As a share of their income, that is 4,800 out of 60,000, or 8%. Notice what happened. The higher earner paid more tax in cash, which is why the tax feels fair, but a smaller share of their income, which is what makes it regressive. Nobody designed it that way and no rate was set differently for anybody. The effect comes entirely from the fact that a smaller proportion of a high income is spent, so a tax on spending simply cannot reach as much of it. That is the shape of a full answer: state the classification, then explain the mechanism that produces it, then say what follows. And notice the qualification a top answer would add: the effect depends on what is taxed, since taxing only things that better-off people buy would not work this way.

From rate to burden

Put the reasoning that makes a spending tax regressive into order.

• A single rate of tax is charged on spending, the same for everybody
• People on lower incomes must spend most of what they receive, largely on necessities
• People on higher incomes spend a smaller proportion of theirs and save the rest
• The tax therefore reaches a larger share of the lower income than of the higher one
• So the tax takes a greater percentage of income from those who earn less, which is what regressive means

The answer that mixes the axes

Four sentences about taxation. Select the ONE that confuses how a tax is collected with who it falls on hardest.

• A direct tax is charged on income or wealth and paid straight to the government by the person charged.
• A tax charged on spending is indirect, which means it is regressive by definition.
• A progressive tax takes a larger share of income from higher earners than from lower ones.
• Taxes on spending tend to be regressive because a smaller proportion of a high income is spent.

Judging a tax change

A government is considering changes to how it raises money. Work through what you would say about each.

• It proposes raising a tax charged on spending. A minister says this is fair because everyone pays the same rate. What is your response?
• A question asks you to classify a tax charged on company profits. What do you need to check first?
• The government wants more revenue without increasing the burden on the lowest earners. Which direction helps?
• You are writing the evaluation. What lifts it into the top band?

Explain revenue, spending and taxation

Explain where a government gets its money and what it spends it on, and explain the difference between direct and indirect taxation and between progressive and regressive taxation.

• Name the main sources of government revenue
• Name the main areas of government spending
• Define direct and indirect taxation in terms of how each is collected
• Define progressive and regressive taxation in terms of the share of income taken
• Explain clearly that these two pairs answer different questions
• Explain why a tax charged on spending tends to be regressive, giving the mechanism
• Finish with a qualification: say what the effect depends on