External environment - Government policy

Theory 2 - Impact of taxation - who is hit hardest?

Income tax (see theory 1 for more detail) is charged at higher rates the more you earn. The effect of this is that the better-off (in terms of income) pay a greater proportion of their income as tax. This means that income tax is progressive.

Alternatively, a tax may be a regressive tax. This is a tax where the more people earn the less the tax represents as a proportion of their income. In other words, regressive taxes will hit less-well-off people harder than the better-off.

The full definitions are:

• Progressive tax - a tax that represents a greater proportion of a person's income as their income rises. In other words, the average rate of taxation rises.
• Regressive tax - a tax that represents a smaller proportion of a person's income as their income rises. In other words, the average rate of taxation falls.
• Proportional tax - a tax where the percentage of income paid in taxation always stays the same. In other words, the average rate of taxation is constant.

The balance of these taxes can have a significant effect on how income is distributed in an economy and therefore how much people spend and on what. If a government chooses to switch the balance of taxation from progressive to regressive taxes then the less-well-off in society will be harder hit.

It will pay businesses to see how these taxes are changed in Budgets as it may change the pattern of demand for their product.