External environment - Government policy

Theory 1 - Types of taxation - is there anything that isn't taxed?

Most of what we do seems to be taxed these days, but what are all these taxes and why do we need them? Well, the government needs money to spend on health, education, law and order and all the other public services. In fact they probably spend more than you realise to provide all these services. For 2004/05 total government expenditure is estimated to be £488 billion. That is over one and a quarter billion pounds each day! So perhaps this starts to tell us why they need to tax so many things.

We can see the main types of taxation from the pie chart shown below:

So what are each of these?

• Income tax - this is probably the most important tax of all, raising well over a quarter of all tax revenue. It is charged on all income, but the rate increases the more income is earned. The first part is tax-free, but then once you have earned this personal allowance the tax rate is 10% for the next chunk of income. The rate then increases to 22% for a while and then to 40% for higher income. The level at which the rate changes is termed the tax band and these tend to be changed in the budget each year to keep up with inflation. A good place to find them out is either on the Treasury Web site or the Institute for Fiscal Studies. Income tax is collected by the Inland Revenue.
• VAT (Value added tax) - this is a tax on spending and is therefore called an indirect tax. VAT is charged at every stage of the production process, but firms can reclaim any VAT they pay, so the only people to actually pay VAT as a tax are the consumers. A firm has to keep a record of all the VAT they have paid on their supplies and all the VAT they have collected on their sales. The latter figure should be bigger and they pay the difference over to HM Customs and Excise who collect VAT. The net effect is that they pay no VAT, but they have to act as the tax collectors for Customs and Excise! The current rate of VAT is 17.5%.
• National insurance - national insurance is paid by both employers and employees. The origins of national insurance are that it is a fund maintained by government to pay out if you are unemployed and when you reach retirement age, so it is a sort of insurance against becoming unemployed or old (though that seems a little unavoidable!). To receive a state pension on retirement, you have to have paid enough national insurance to qualify, so it is in essence a fund that entitles you to certain benefits.
• Corporation tax - this is the main business tax. This is charged on company profits and the rate varies according to the size of the business. It is effectively an income tax for business as their income is their profit. Business do also have to pay local business taxes (business rates) to local authorities in the area they are located in, but corporation tax is collected by the Inland Revenue.
• Excise duties - these are also taxes on spending and so are termed indirect taxes, but they are taxes on specific goods. Excise duties are charged on alcohol, tobacco, petrol and gambling. They are collected by HM Customs and Excise and tend to be increased each year in the Budget. This is because they are usually set at a fixed rate and so need to be increased to ensure that the revenue from them keeps up with inflation. Many of them are also intended to try to reduce consumption because of the harmful social costs that may be generated as a result (pollution from petrol, etc.).