Significance

Money earned by the State thanks to taxation. It is the main income for the state, funding public expenditure and other items, tangibly expressing the common efforts of the community.

Taxes are good ways for financing the costs of public goods, a special group of goods whose consumption by one person does not decrease the consumption by others and, at the same time, for which it is costly or impossible to prevent consumption (e.g. street lightening). A normal pricing for these goods would arrive to a zero-level price; thus, it would provide no incentives to supply.

Similarly, it is common to finance by taxes the costs of goods and services having large positive externalities if they are not supplied enough by the private sector.

Taxes are mandatory payments, ruled by laws. Tax revenue is collected from the whole society with differentiated intensity, inspired by considerations of justice, efficiency and effectiveness.

In particular, the tax system can have the broad goal of reducing income inequality.

Taxes can be considered as ex-ante payments for services obtained later on (allowing for de-coupling of the payment structure from consumption structure but not necessarily). The can also be seen as premium payments for insurance schemes.

Many fiscal system, however, are highly irrational, exceedingly complex and the taxpayer risks to need a professional advice for computing the tax amount and for figuring out ways to decrease the tax burden. They can pay for wasteful expenditure, especially of the political and economic élite. Reaction to taxation can shape electoral behaviour.

Taxes contribute to the repayment of cumulated public debt (principal) and the related interest paid on it. However they quickly become untolerated by the electorate if the share devoted to such goals becomes too large, compressing public expenditure amount, coverage and quality, since most voter will feel to receive less than they pay in taxes.

Composition

The tax revenue is the sum of the revenues of different kind of taxes, depending on what is taxed:

1. the revenue of physical and juridical persons ("direct taxes");

2. wealth and assets as real estates and houses;

3. the domestic economic transactions, especially for consumption purposes ("indirect taxes" - e.g. VAT), including "bad habits" (sin taxes);

4. international trade, typically through import duties;

5. financial transactions, both in domestic and in international terms.

Determinants

Tax revenue is the result of the application of a tax rate to a tax base. Increases in tax base result in more socially acceptable increase in revenue than an increase in the rate, which in turn, in certain macroeconomic conditions, could even backfire.

Taxes are ranked according to the tax rate:

1. progressive taxes, with a tax percentage rate growing with the amount taxed;

2. proportional taxes, with a tax rate constant whatever the tax base;

3. regressive taxes, with falling tax rate whilst increasing base;

4. lump sum taxes, with a fixed absolute value of the tax, irrespective of the tax base.

Thus, the income distribution and tax base dynamics are key determinants for the revenue from progressive, proportional and regressive taxes, whereas it becomes irrelevant for lump sum taxes.

Fiscal systems differ a lot throughout the world but usually the personal revenue tax is progressive, the firm revenue tax is proportional as well as the taxation of domestic and international economic activity. Also wealth taxation is usually proportional, with some use of lump sums.

Lump sums are particularly common for taxes of a small absolute value.

Progressive taxes have the advantages of producing a large revenue from a small number of taxpayers, which are in political minority. Their political acceptance in selfish voters can thus be high. Taxes on what is considered as "bad" (e.g. pollution, smoking, drinking alcohol) are also more justifiable from a moral point of view (and offer to the "good-habit" people the possibility of escaping the tax), so usually they are politically sustainable.

However, depending on the political climate and parties' position an increase in taxation may be electorally toxic.

In macroeconomic terms, GDP dynamics is a major determinant of tax revenue. The higher the GDP, the larger the tax base, the higher the tax revenue.

The credible capability of raising tax revenues up to fully meet debt principal due and interests to creditors is the key indicator for the sustainability of public debt.

The credibility of extracting enough tax revenue to this aim is directly linked to the overall GDP amount (as too high tax rates are considered unlikely and having a depressing effect on GDP itself) as well as the political acceptability of taxes. This, in turn, depends on how fair the tax system is considered by voters and whether a majority estimates to be receiving from public expenditure more than it gives in taxes.

The more progressive the tax system, the larger this majority is (since only a few rich bear the burden of giving much more than they receive).

Politicians that state that tax avoidance is acceptable undermine the credibility of the tax power, so they can bring a country on the brink of bankruptcy, somehow irrespective of how high is debt with respect to GDP.

International competition across fiscal systems can hinder the possibility for a state to tax mobile items, whereas providing a strong incentive to international coordination (e.g. against tax havens).

Fiscal systems differs in terms of transparency, simplicity, use of threshold for exemptions, ways to deduct bills, etc. to the effect that, in certain countries, the work of tax accountants is very important for final effective taxation.

Impact on other variables

An automatic increase of tax revenue generated by a larger tax base is welcomed to the public balance, reducing the deficit or even producing a surplus.

An intentional increase of the tax rate would instead reduce the disposable income of households. Both consumption and savings will go down, unless other dynamics are taking place at the same time.

Higher taxation on specific items could be a disincentive for related behaviours. This can give rise to a specific set of taxes purposefully aimed at reducing those behaviours, as in the case of cigarettes. A careful mix of tax and subsidies can exert a powerful impact on the diffusion of an innovation, as with the case of a PRODINT: pro-diffusion-of-innovation tax.

Certain social groups can be hurt by taxation (both in total level and through specifical hideous taxes, especially if recently introduced) to the effect of changing their electoral behaviour and support anti-tax parties and policymakers. For instance, property taxes unrelated to income may painfully impact low-income homeowners.

Taxation remedies for (or exacerbates) unbalances between desired aggregate investment and savings. By taxing the rich, and more in general people with large savings, and spend in public goods conducive to private investment (or directly productive public investments), the government spurs modernization and GDP growth. However, in certain business cycle conditions, and if public investment is highly irrational and wasteful, the opposite result is achieved, by depressing private entrepreneurship and social pain.

Long-term trends

Wherever the State plays an important role in the country development and it supplies education, healthcare, social assistance, the tax revenue is proportionally high.

Where the tax revenue has not been covering the public expenditure, the burden of the public deficit has cumulated leading to the public debt, on which the state has to pay interests, in some extreme cases triggering a vicious cycle.

The tax revenue has been increasing for most of the 20th century, with its percentage on GDP reaching a ceiling and then falling, due to fiscal protests.

In developing countries, the tax base of direct taxes is constrained by a large informal sector, as this paper explains.

Business cycle behaviour

Linked to GDP dynamics as it is, the tax revenue is pro-cyclical. In recessions, tax revenues fall because of narrower base - and possibly because of tax rate cuts made by the government in name of stimulating the economy. In booms, tax revenues rise because of larger base, and possibly because of higher tax rate introduced to reduce the public deficit (which usually soared because of the previous free-falling tax revenues and possibly of public expenditure increases made to stimulate the economy).

During the business cycle, taxes may act as automatic stabilisers, having an elasticity to GDP changes often larger than one, i.e. with an over-reaction to changes in GDP, which in turn makes the disposable income fluctuate less than GDP.

By contrast, many taxes takes for reference the previous year tax base, as with the case of income taxes. This means that a one-year lag may characterise the overall tax revenue and thus, in certain occasions, be destabilising.

Data

Tax revenue in OECD countries (1966-2000) plus a comparison in tax systems

Tax rate and business friendliness in 183 countries (2011)

Tax revenue composition (income personal and corporate tax, indirect tax,...)

Regressive and progressive tax systems in USA: a comparison across States

US Data for all the variables in IS-LM model

EU data for all the variables in IS-LM model (Germany, France, Italy, Spain, UK, Switzerland and other 13 European countries)

Environmental taxes in 15 countries (1980-1999)

Indirect taxes - Canada (1926-1976)

Formal models

An interactive map of how the economy works according to a basic macroeconomic scheme: the IS-LM model

Related papers

Taxation base in developing countries

Many sub-Saharan African countries face difficulty in raising tax revenue for public purposes. Low per capita incomes, an economic base in subsistence agriculture, poorly structured tax systems, and weak tax and customs administrations all contribute to difficulties in raising tax revenues. This study uses panel data on 43 sub-Saharan African countries to measure the determinants of the tax share in GDP

Korea tax system: an historical and structural overview