The Principles of Taxation

2. Tax classifications and tax vocabulary

Such a wide variety of taxes exist that it is useful to attempt to classify them.

A standard, but not very useful classification of taxes is into direct and indirect taxation.

Before we say much about this, we need to look at the notion of tax incidence.

The simplest notion of tax incidence (formal incidence) concerns the question of

Thus, the formal incidence of an income tax falls on the income earner the formal incidence of a petrol tax falls on the petrol company. This is not at all informative from an economic point of view. Obviously, in the latter case, the petrol company may pass on an increase in tax in the form of higher prices. expenditure).

By so doing the company shifts the burden of the tax on to the consumer (this is known as forward shifting of the tax burden).

We might then say that the effective incidence or economic incidence of the tax falls on motor vehicle owners. However, if we look more deeply we may be able to distinguish a number of other effects. Some vehicle owners (taxidrivers, bus companies, carrying firms) may be able to pass the increased cost of petrol on to others. Thus, part of the effective incidence of an increase in petrol tax may be on bus passengers or on consumers of food transported by lorries

. Yet again, suppose the consequent increase in bus fares causes a reduction in bus travel. Bus companies may respond by reducing the number of buses they run on some routes and may reduce the working hours of some bus drivers who then bear part of the burden of the increased petrol tax. Again, bus company profits may be reduced leading to lower dividends being paid to shareholders.

It is possible to come to some theoretical conclusions about the possibility of shifting the tax burden.

For instance, it can be shown that if a tax were applied to a good that was perfectly inelastic in demand, producers would be able to shift the full burden of the tax on to consumers. On the other hand, with perfectly elastic demand, it would be impossible for producers to increase the price of the product to take account of the tax - the tax burden would be borne fully by the producer. Of course, in the usual cases where demand is somewhere between perfectly elastic and perfectly inelastic, the burden would be divided amongst consumer and producer but the more price-inelastic was demand, the more of the burden would be shifted on to the consumer.

But theoretical propositions such as these are not a great deal of help in sorting out what the actual incidence of a particular tax is since the effects of a tax may be very widespread, reaching to all parts of the economy. It is certainly clear that the effective incidence of a tax may have very little to do with who actually hands the money over to government in the first instance.

The usual distinction between direct and indirect taxes, then, is that a direct tax is one for which the formal and economic incidence are essentially the same - that is, the taxpayer is not able to pass the burden on to someone else.

Thus income tax counts as a direct tax but VAT counts as an indirect tax because the tax burden may easily be passed on. This is not satisfactory in economic terms because whether or not an increase in VAT can actually be passed on in the form of higher prices will depend on market conditions. VAT may, in principle, be passed on but there may be many occasions in which this is not done.

Again, during periods of very tight labour markets, some workers may well be able to demand higher wages to make up for increased income tax, in effect passing the tax on to employers and hence, through higher prices, on to consumers.

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Hence, it is usual to acknowledge the direct/indirect distinction but to go on to use some other classification. One possibility is to follow Sandford and classify taxes as taxes on (a) income (b) capital (wealth) or outlay (expenditure).

Musgrave and Musgrave distinguish between taxes on people and taxes on things.

Another distinction sometimes made is between taxes on stocks (wealth) and taxes on flows (income,

Both Brown and Jackson (1990, pp. 306-7) and James and Nobes (1998, pp. 12-13) reproduce the much more complex OECD classification which includes seven principal headings with a number of sub-headings under each one.

The sevenprincipal headings are:

1000 Taxes on goods and services

2000 Taxes on incomes, profits and capital gains

3000 Social security contributions

4000 Taxes on employers based on payroll or manpower

5000 Taxes on net wealth and immovable property

6000 Taxes and stamp duties on gifts, inheritances and on capital and financial transactions

7000 Other taxes

Taxes involve two elements: the tax base and the tax rate.

The tax base describes what the tax is levied on.

Thus, the tax base of VAT is the value added at each stage of production to all goods and services minus those goods which are exempt and those that are taxed at a zero rate. Tax rates are then applied to the tax base to determine the amount of tax payments to be made.

The majority of taxes are ad valorem taxes - that is, taxes are based on values.

Excise duties are specific taxes - that is, the base is not the value of a product but a physical quantity (so much tax per pint of beer or per packet of twenty cigarettes).

There is one type of tax, a poll tax, where the tax payable is not related at all to the tax base.

The Principles of Taxation