Tax the Nightmare of Earners

If you are a person living in the modern-day economy then there is a nightmare topic that haunts individuals with money even during sleep. Any guesses? If your guess is Tax, then you are right. In this post, we are going to understand tax, its history, different types of tax, and its use.

So first let’s understand what tax is.

What is Tax?

To put it forth simply tax is a mandatory contribution collected by the government from individuals or businesses. These contributions finance government activities, including public services like roads, schools, hospitals, programs such as Social Security and Medicare, and other important activities for the progression of the nation such as Research and Development and Defence.

In essence, tax helps fund the betterment of the economy and the well-being of all residents.

History of Tax

Taxation has a long and fascinating history, evolving significantly over centuries. Let’s have a look at some of the ways and periods when tax has existed in history.

Ancient Civilizations:

In ancient civilizations, there are mention of tax in different forms. For example, in Egypt around 5,000 years ago, the Pharaohs collected tax equivalent to 20% of all grain harvests. Both had various forms of taxes, including consumption taxes and tariffs. Julius Caesar introduced a 1% sales tax, which was later increased to 4% under Caesar Augustus.

Middle Ages:

During this period, many ancient taxes gave way to obligatory services and a system of “aids”, which were essentially gifts. indirect taxes like transit duties and market fees became common.

Modern era:

Modern Era refers to the present era. The first income tax was introduced during the Civil War in the United States, but the federal income tax as we know it was officially enacted in 1913. Various forms of taxation evolved, including property taxes, sales taxes, and income taxes, which became more structured and widespread.

Taxation has always been a crucial tool for governments to fund public services and infrastructure, and its methods and structures have continuously adapted to the needs and complexities of societies.

Use of tax

Till now we have understood what is tax and its history. But what is the use of collecting this tax? To understand this what is the function of governments? Governments are elected to represent people and keep societies running smoothly. Well, there are certain duties or obligations governments have to fulfill towards their people, and for this they require funds. So the tax money acts as the fund for this. Let’s understand these duties or obligations.

Funding Public Services:

Governments are expected to provide critical and basic services such as education, healthcare, infrastructure development, and public safety for the benefit of the people who have elected them. They need funds for the activities that comprise these services such as building schools, hospitals, and public spaces, and employing people to run these places smoothly.

Income Redistribution:

Governments also try to maintain balance in society by trying to transfer the burden of tax to people who earn more, so that people who earn less can meet their basic needs. They also declare schemes from time to time to help people of the lower class so that they can climb up the ladder. These are funded by the tax money.

Economic Stability:

Tax revenue stabilizes government finances. It allows governments to implement counter-cyclical policies during economic downturns. These policies can include stimulus spending or unemployment benefits to support citizens during tough times.

Taxes are what we pay for a civilized society.

Different types of tax and calculation

Till now we have understood tax and its uses. Now let’s see the different types of tax and how they are collected. Taxes can be classified into types broadly.

1. Direct Taxes

Direct taxes as the name suggests are paid by individuals or organizations directly to the government. Some of the different types of Income tax are given below.

it is characterized by direct payment that is the taxpayer is paying the tax directly to the government, and the burden of the tax cannot be shifted to another party.

Income Tax:

Levied on individuals and organizations and income tax is paid based on their earnings. The tax rate typically increases as income rises. Taxable income includes salary, interest, dividends, capital gains, and other sources of income. Deductions and exemptions may reduce the taxable amount.

The formula for income tax is straightforward: Income Tax=Tax Rate×Taxable Income.

Property Tax:

Imposed on Real Estate and sometimes on personal property. Property tax is based on the assessed value of real estate (land and buildings). Local governments levy property tax to fund public services. The formula is:

Property Tax=Assessed Value×Tax Rate

Corporate Tax:

Applied to profits of corporations. Businesses pay corporate tax on their profits. The formula is similar to income tax:

Corporate Tax=Tax Rate×Profit

Wealth Tax

Levied on the net wealth of individuals and entities. This tax is not in practice everywhere as with other types of taxes.

Capital Gains Tax

This tax applies to profits from selling assets (stocks, real estate, etc.). The rate depends on how long you hold the asset. The formula is:

Capital Gains Tax=Tax Rate×(Selling Price−Purchase Price)

Other Taxes

There are many other taxes, such as estate, gift, and excise, each with its own calculation method.

2. Indirect Taxes

Indirect taxes are taxes levied on goods and services rather than on income or profits. A tax is collected by an intermediary (such as a retailer or manufacturer) from the person who bears the ultimate economic burden of the tax (such as the consumer). The intermediary then remits the tax to the government.

Indirect taxes are often considered regressive because they take a larger percentage of income from lower-income earners than from higher-income earners. This is because everyone pays the same rate regardless of their income. Consumers may not always be aware of the indirect taxes they are paying, as these are included in the price of goods and services.

Indirect taxes are relatively easy to collect since they are included in the price of goods and services. They can generate significant revenue for governments because they apply to a wide range of goods and services.

Indirect taxes are a crucial part of many countries’ tax systems, providing a steady revenue stream while being relatively easy to administer.

Sales Tax:

Sales tax is usually a percentage of the purchase price of goods or services. For example, if the sales tax rate is 8% and you buy an item for INR 100, the tax would be INR 8. Some regions have different rates for different types of products (e.g., essentials vs. luxury items).

Value Added Tax (VAT):

A type of consumption tax is placed on a product whenever value is added at each stage of the supply chain, from production to the point of sale.

Excise Tax:

Levied on specific goods, such as alcohol, tobacco, and fuel. The manufacturer or producer pays the tax, which is then passed on to the consumer through higher prices.

Custom Duty:

Taxes on imports and exports. Importers pay these taxes when goods enter a country, and the cost is typically passed on to consumers.

Progressive taxation

Progressive taxation is a system where the tax rate increases as the taxable income increases. This means that individuals or entities with higher incomes pay a higher percentage of their income in taxes compared to those with lower incomes.

Tax Brackets:

Progressive tax systems typically use tax brackets, where income ranges are taxed at different rates. For example, in the U.S., tax rates range from 10% to 37% depending on the income level, in India Tax rates vary from 5% to 30% depending on income level.

Redistributive Effect:

The primary goal of progressive taxation is to reduce income inequality by redistributing wealth from higher-income earners to lower-income earners. This is based on the principle that those who have more should contribute more to society.

Economic Impact:

Progressive taxes can help stimulate the economy by leaving more disposable income in the hands of lower-income earners, who are more likely to spend it on essential goods and services.

However apart from the above positive points some critics argue that progressive taxation can be a disincentive to success and may unfairly penalize higher earners. They also contend that it can lead to excessive government intervention in the economy.

Overall, progressive taxation aims to create a fairer tax system by ensuring that those with greater financial resources contribute a larger share of public revenues.

Progressive vs Flat Tax System

We have seen what is progressive taxation in the previous section. In this section, we will see the difference between Flat and Progressive taxation systems.

The key differences between progressive and flat tax systems can be summarised as follows:

• Equity: Progressive taxes aim to achieve greater equity by taxing higher incomes at higher rates, while flat taxes treat all income levels the same.
• Complexity: Progressive systems are more complex due to multiple tax brackets and deductions, whereas flat tax systems are simpler and easier to administer.
• Economic Effects: Progressive taxes can help reduce income inequality but may discourage high earners. Flat taxes can simplify the tax code but may increase income inequality.

Impact of taxes on economic growth

The impact of taxes on economic growth is a complex topic, but we’ll try to get a concise overview based on historical evidence.

Lower income tax rates increase consumers’ spending power and can boost aggregate demand, leading to higher economic growth. Income tax cuts may also increase incentives to work, ultimately enhancing productivity.

However high marginal tax rates can discourage work, saving, investment, and innovation. Specific tax preferences can affect resource allocation. However, tax cuts can also slow long-run economic growth if they lead to increased deficits.

Studies consistently show a negative relationship between income tax rates and gross domestic product (GDP). Recent evidence confirms that tax cuts positively affect growth, especially on corporate and individual income. The impact depends on which taxes are cut, for whom, and when.

Tax saving provisions

Now we have seen what tax is, what the different types of taxes are, and what the different types of taxation systems are. Now you might be thinking is there any way to reduce this tax liability on an individual or business? So now coming to the main adrenaline thing, there are provisions provided by every government for people to reduce their tax liability.

To understand this we will take the example of India. Here the government has provided some provisions for individuals and companies to reduce their tax liability. In this example, we will take employees as an example for understanding the provisions for reducing tax.

Section 80D

This section allows employees to claim deductions for expenses incurred for health and Life insurance policies. However this doesn’t allow for any amount of cost incurred, there is capping for individuals is INR 25K and for senior citizens is INR 50K.

Section 80 C

This section allows employees to claim deductions for investing in retirement instruments such as ELSS, EPF, NPS, etc, and the amount paid as principal for the home loan. This section has a capping of INR 1.5 lacs.

Section 80 CCD (1B)

This section is an extension of 80 C and offers an extra deduction of INR 50K for investing in retirement instruments.

Section 24 (B)

Under this section, an employee can claim an exemption of the interest amount paid back for the home loan taken. The capping of this section is at INR 2 lakhs per year.

Section 80 EE

This is an extension of Section 24 and employees are given an extra deduction of INR 50K.

So to summarize this all the total deductions available for employees is INR 5 Lakhs per year including the standard deduction of INR 50K. Kindly note that these cappings can change based on the budget declared by the government for that financial year, and the deductions mentioned here are the commonly known deductions used by employees.

This is all for this post. Let me know your thoughts in the comments section. Don’t forget to follow my Facebook and Instagram Pages for regular updates. See you all in the next post. Till then keep learning.