Equality: what progressive income taxes giveth, consumption taxes taketh away

There are two broad types of taxes: direct and indirect.

Direct taxes are charged directly by governments, usually on income. This facilitates progressive targeting, taking more from high earners and alleviating the  burden on the poor.

Indirect taxes (e.g. VAT, GST, fuel and tobacco levies) are charged by anyone providing a good or service upon consumption. And the 7–Eleven down the street doesn’t know whether you are rich or poor. So a chocolate bar will incur a 20% tax, whether you earn £10,000 or £100,000.

 

How much does this matter?

The impact of indirect taxes depends on how much you earn. Unfortunately, the less you have the more it impacts.  While income tax progressively increases as your income increases, consumption taxes are regressive. As a result the poorest 10% of UK’s households spend a third of their income on indirect taxes.  The richest 10% on the other hand only spend £1 of every £10 they earn in indirect taxes¹.

The impact of these regressive indirect taxes are such that they cancel out the progressiveness of the income taxes.  That is, once both sets of taxes are considered; households across the UK’s income spectrum contribute the same amount relative to their income. In fact, the poorest 10% of households contribute 10 percentage points more than any other income group.

This trend grew drastically from the late 70s till 2002, and appears to have plateaued since. But it does not appear to be disappearing.

 

But, what if…

…  the UK got rid of indirect taxes. What if it raised the same revenue as it does today entirely through income taxes, using its current progressive pattern?

Using this ‘what if’ scenario, some measures of inequality would be almost halved:

To put the Gini value in perspective, the estimated 0.26 value would put the UK among the most equal countries, alongside Norway, Finland (based on UNDP figures²).

 

Removing the VAT by itself would make a significant impact, as it accounts for almost half of all indirect taxes.

 

Reality check

Granted, moving to an entirely direct revenue raising system is neither likely nor simple. But this ridiculous scenario does highlight just how unequal the indirect taxing system is, and what impact it has on equality.

It also suggests that every new or increased indirect tax implemented continues to drive a wedge between the haves and the have-less. This includes the increases in VAT from 15% to 17.5% to 20% over the past 25 years, and any additional levy.

Similarly, if a key aim over the coming years is to decrease inequality, then there may be worse places to start than by lowering VAT, and compensating where necessary with increased income taxes.

 

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Sources:

[1] http://www.ons.gov.uk/peoplepopulationandcommunity/personalandhouseholdfinances/incomeandwealth/datasets/averageincomestaxesandbenefitsbydecilegroupsofallhouseholds

[2]  http://hdr.undp.org/en/content/income-gini-coefficient