Tax Policy

Types of Taxes

It is conventional to distinguish between direct and indirect taxes. A direct tax is paid directly to the government by the (natural or legal) person on whom it is imposed. Direct taxes are usually based on the taxpayer's ability to pay. The most important direct tax is the individual income tax levied on the labor, capital, or other income of a person or household. Other important direct taxes include the corporate income tax on business profits, the property tax on real estate holdings, the wealth tax on net worth, the inheritance tax on bequests, and social security contributions. An indirect tax is paid to the government by a person different from the person on whom it is imposed. The most important examples are general consumption taxes, such as the value-added tax (VAT) or the sales tax, and specific consumption taxes, such as excises on fuel, tobacco, or alcohol. These taxes are indirect in the sense that they are imposed on the consumers of goods and services but paid to the government by the seller of the goods or services. In contrast to direct taxes, indirect taxes cannot take into account taxpayers' ability to pay. While poor people usually pay less income tax, absolutely and relatively, than rich people, they always pay the same rate of VAT or excise.

Another typology sorts taxes according to their presumed distributive effect. The individual income tax is usually considered a progressive tax because it typically combines a progressive statutory rate schedule with a personal exemption for a minimum level of income. Both features ensure that income earners pay progressively more of their income in tax the higher their earnings. Corporate income, property, and wealth taxes are also often considered to be progressive. Social security contributions, by contrast, can be considered proportional to the extent that they are charged at flat [Page 2584]rates and with little or no personal exemption. Often they are charged only up to a maximum level of income. This tends to make their distributive effect regressive because taxpayers with incomes above the income cap owe an ever smaller share of their income to social security contributions the more they earn above the income cap than taxpayers with income below the cap. General consumption taxes and excises are commonly considered to be regressive because the share of income spent on consumption tends to decrease as the level of personal income increases. The theoretical basis for distinguishing taxes according to their distributive impact is shaky, however. The link between corporate income taxation and tax progressivity, for example, is by no means clear and crucially depends on assumptions about incidence. There is also empirical evidence to suggest that common intuitions about the distributive effects of taxes are often inaccurate. For example, income and property taxes are not invariably progressive in end effect and may sometimes even be regressive.

...