Examples of the different classifications of tax: progressive, regressive, proportional; direct, indirect

Government and the Macro‑economy – Fiscal Policy

Learning objective

Identify, explain and evaluate the different classifications of tax (progressive, regressive, proportional; direct, indirect), give relevant UK and non‑UK examples, and understand how tax policy is used in fiscal policy to achieve the macro‑economic aims of the Cambridge IGCSE/A‑Level syllabus.

1. Definition of taxation

Taxation is the compulsory collection of money by a government from individuals, households or businesses to finance public services and achieve broader economic objectives.

2. Why governments tax

• Revenue generation – funds health, education, defence, welfare, etc.
• Redistribution of income and wealth – reduces inequality (e.g., progressive income tax, means‑tested benefits).
• Correction of market failure – discourages demerit goods (tobacco, alcohol) and encourages merit goods (education, renewable energy).
• Environmental sustainability – internalises external costs (carbon tax, plastic‑bag levy).
• Stabilising the economy – influences aggregate demand through changes in disposable income.
• Fiscal tools beyond tax – the National Minimum Wage (NMW) is a government‑mandated floor that raises low‑pay earners’ income and can be viewed as a redistribution measure linked to tax policy.

3. Main types of taxes (UK & non‑UK examples)

4. Classification of taxes – by rate structure

4.1 Progressive tax

The tax rate rises as the tax base (normally income) increases, so higher earners pay a larger *percentage* of their income.

4.2 Regressive tax

The effective tax rate falls as the tax base rises; low‑income households therefore pay a larger *share* of their income.

• Uniform VAT or sales tax applied at a single rate to all purchases.
• Excise duties on fuel, tobacco or alcohol (same amount per litre/cigarette regardless of income).

Example (non‑UK): Sweden’s 25 % VAT is regressive because low‑income families spend a higher proportion of their income on taxed goods.

4.3 Proportional (flat) tax

The same rate is applied to every level of the tax base.

5. Classification of taxes – by incidence

5.1 Direct taxes

Legal liability rests with the person or organisation on which the tax is levied.

• Income tax (individuals)
• Corporation tax (companies)
• Capital gains tax
• Council tax / property tax (UK)
• National Minimum Wage (a statutory wage floor, not a tax but a direct fiscal tool)

5.2 Indirect taxes

Collected by an intermediary (retailer, importer) from the consumer and then passed to the government.

• Value‑added tax (VAT) / sales tax
• Excise duties (tobacco, alcohol, fuel)
• Customs duties
• Carbon tax (when added to the price of fuel or electricity)

6. Tax‑rate calculations

• Flat or proportional tax:
  

  Tax = Rate × Tax‑base

• Effective (average) tax rate:
  

  Effective rate = (Tax paid ÷ Income) × 100 %

• Progressive tax – bracket method:
  

  Tax is calculated separately for each income band and summed.
  

  Worked example (UK, £30,000 taxable income):

  • £0‑£12,570 @ 0 % → £0
  • £12,571‑£30,000 @ 20 % → (£30,000‑£12,571) × 0.20 = £3,486
  • Total tax = £3,486 → Effective rate = £3,486 ÷ £30,000 ≈ 11.6 %

7. Impact of a tax change on market outcomes

When a per‑unit tax is imposed on a good, the supply curve shifts upward by the amount of the tax.

• Consumer price (Pc) rises by the portion of the tax that falls on buyers.
• Producer price (Pp) falls by the portion that falls on sellers.
• The split depends on the relative price‑elasticities:

  • If demand is inelastic and supply is elastic, most of the tax burden falls on consumers.
  • If supply is inelastic and demand is elastic, producers bear a larger share.

• Quantity traded falls, reducing both consumer surplus and producer surplus.
• Government revenue = Tax × Quantity sold after the tax.

8. Fiscal policy – using taxes and spending

• Expansionary fiscal policy: lower taxes and/or increase government spending to raise aggregate demand, aiming for higher growth and lower unemployment.
• Contractionary fiscal policy: raise taxes and/or cut spending to reduce demand, helping to control inflation.
• The budget balance matters – a tax cut financed by borrowing raises the deficit, while a tax increase paired with spending cuts can be neutral for the public sector borrowing requirement.

9. Evaluation of tax‑based fiscal policy

10. Link between tax policy and macro‑economic aims

11. Environmental taxes – examples

• Carbon tax – charge per tonne of CO₂ emitted; e.g., UK Carbon Price Floor (£18 / tonne).
• Plastic‑bag levy – fixed charge per disposable bag; e.g., UK £0.10 per bag.
• Vehicle excise duty (based on emissions) – higher rates for higher‑emission cars.

These are generally indirect taxes and can be structured as proportional (same charge per unit) or progressive (higher rates for higher emissions).

12. Summary of tax classifications

13. Quick‑check questions

1. Which type of tax is most likely to reduce income inequality?
   Answer: Progressive tax.
2. Why can a uniform VAT be considered regressive even though the rate is the same for everyone?
   Answer: Low‑income households spend a larger share of their income on taxed goods, so the tax takes up a higher proportion of their total income.
3. Classify each tax as direct or indirect:

   1. Road fuel duty – Indirect
   2. Council tax (property tax) – Direct
   3. National Minimum Wage – Direct (fiscal tool, not a tax)

4. Explain how a rise in corporation tax could affect (i) government revenue, (ii) investment, and (iii) unemployment.
5. Sketch a simple tax‑incidence diagram for a per‑unit tax on cigarettes and label the consumer price, producer price and tax revenue.