What is Taxation

The primary function of taxation is, of course, to raise revenue to finance government expenditure


A tax is a payment of money legally demanded by a government authority to meet public expenses.

Everyone knows that taxation is necessary for a modern state: without it, it would not be possible to pay the soldiers and policemen who protect us; nor the workers in government offices who look after our health, our food, our water, and all the other things that we cannot do for ourselves, nor also the ministers and members of parliament who govern the country for us. By means of taxation we pay for things that we need just as much as we need somewhere to live and something to eat.

But though everyone knows that taxation is necessary, different people have different ideas about how taxation should be arranged. There are two main ways, by which taxes may be paid:

1) Each person has to pay a certain amount of money to the government each year;

2) There is a tax on things that people buy and sell.

In most countries, a direct tax on persons, which is called income tax exists. It is arranged in such a way, that the poorest people pay nothing, and the percentage of tax grows greater as the taxpayer’s income grows.

But countries with direct taxation nearly always have indirect taxation, too. Many things imported into the country have to pay taxes or “duties”. Of course, it is the men and women who buy these imported things in the shops who really have to pay the duties, in the form of higher prices. In some countries, too, there is a tax on things sold in the shops. If the most necessary things are taxed, a lot of money is collected, but the poor people suffer most. If unnecessary things like jewels and fur coats are taxed less money is obtained, but the tax is fairer, as the rich pay it.

Probably, this last kind of indirect tax together with a direct tax on income which is low for the poor and high for the rich is the best arrangement.

The primary function of taxation is, of course, to raise revenue to finance government expenditure, but taxes can also have other purposes. Indirect excise duties, for example, can be designed to dissuade people from smoking, drinking alcohol, and so on. Governments can also encourage capital investment by permitting various methods of accelerated depreciation accounting that allow companies to deduct more of the cost of investments from their profits, and consequently reduce their tax bills.

There is always a lot of debate as to the fairness of tax systems. Business profits, for example, are generally taxed twice: companies pay tax on their profits (corporation tax in Britain, income tax in the USA), and shareholders pay income tax on dividends. Income taxes in most countries are progressive and are one of the ways in which governments can redistribute wealth. The problem with progressive taxes is that the marginal rate – the tax people pay on any additional income – is always high, which is generally a disincentive to both working and investing. On the other hand, most sales taxes are slightly regressive, because poorer people need to spend a larger proportion of their income on consumption than the rich.


In many countries, taxes are quite fair and do not harm interests of the citizens. It may exist in countries, where the expenditures of the government are not very high and consequently it need not collect high taxes or the government has other sources of income, such as profitable business activities. Or the police of the state is to give more freedom to business to make the economic situation better. But some governments have insufficient money to finance its expenditures and they increase tax rates as an alternative of borrowing money. Or they may limit unnecessary business activities. This, of course, decreases the incentive to work, because profits become very small and many businessmen try to hide their incomes. There are lots of methods, both legal and illegal, to hide profits from taxation. For example, tax avoidance (reducing the amount of tax you pay to a legal minimum) or tax evasion (making a false declaration to tax authorities).

The higher the tax rates, the more people are tempted to cheat, but there is a substantial «black» or «underground» economy nearly everywhere. In Italy, for example, self-employed people – whose income is more difficult to control than that of company employees – account for more than half of national income. Lots of people also have undeclared, part-time evening jobs (some people call this «moonlighting») with small and medium-sized family firms, on which no one pays any tax or national insurance. At the end of 1986, the Director of the Italian National Institute of Statistics calculated the size of the underground economy, and added 16.7% to Italy’s gross national product (GNP) figure, and then claimed that Italy had overtaken Britain to become the world’s fifth largest economy.

To reduce income tax liability, some employers give highly-paid employees lots of  «perks» (short for perquisites) instead of taxable money, such as company cars, free health insurance, and subsidized lunches. Legal ways of avoiding tax, such as these, are known as loopholes in tax laws. Life insurance policies, pension plans and other investments by which individuals can postpone the payment of tax, are known as tax shelters. Donations to charities can be subtracted from the income on which tax is calculated.

Companies have a variety of ways of avoiding tax on profits. They can bring forward capital expenditure (on new factories, machines, and so on) so that at the end of the year all the profits have been used up; this is known as making a tax loss. Multinational companies often set up their head offices in countries such as Liechtenstein, Monaco, the Cayman Islands, and the Bahamas, where taxes are low; such countries are known as tax havens. Criminal organizations, meanwhile, tend to pass money through a series of companies in very complicated transactions in order to disguise its origin from tax inspectors – this is known as laundering money.

Source by Michael Newman