How Tax Works

Taxation is the main way in which governments raise revenue needed to pay for public spending. Governments may tax the public directly (for instance, through income tax) or indirectly (via VAT for example). 

How it works

Governments have the unique privilege of being able to demand that anyone in their country pay taxes. These can be divided into "direct" taxes, which are paid from earnings, either by people or institutions, and "indirect" taxes, which are paid for out of consumer spending. Taxes can be levied as a share of spending or income, or as a flat rate. A progressive tax system is one in which richer individuals pay proportionately more tax. Questions surrounding the level of taxation are hotly debated. As a result levels of taxation, and laws about who or what pays for which taxes, vary significantly from country to country.

Taxes and behavior

Some taxes are designed to reduce the amount of revenue that goods earn. Because a newly-levied or increased tax on a product puts up its price, that item becomes less attractive to buy. Where a product is harmful, higher taxes such as on cigarettes can be a way to reduce public consumption. In cases where consumer behavior does not alter much in response to higher pricing, however, the extra tax is likely to raise much more money. This can make some taxes very appealing for governments looking for revenues. 

Direct and indirect taxes

People have to pay taxes on either their income, or on what they spend. Some typical taxes on an individual in the US are shown below.

Need to know

> Tax return: A document used by individuals and businesses to record income.

> Tax rate: The amount at which an individual or a company is taxed; rates vary according to a person's income or a company's returns.

> International agreements: Contracts that act as a restraint on taxation, such as in stopping import duties from being levied.

Tax evasion and avoidance

Because tax systems vary so widely from country to country, it is possible to exploit the differences in international tax rates in order to reduce the total amount of tax due. This is termed tax "evasion" when it is done illegally, and tax "avoidance" when performed legally, although in practice the boundaries between the two are blurred. Some jurisdictions deliberately set very low tax rates to attract investment; some also provide secrecy around the identity of those investing there. This has led to accusations that such areas are acting as "tax havens." This means that, instead of providing a legitimate location for economic activity, they are allowing major corporations and the very wealthy to avoid paying taxes they should be paying.