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To what extent is income tax in the UK progressive? Discuss the likely effect of a cut in rates of income tax on the UK economy.

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Introduction

To what extent is income tax in the UK progressive? Discuss the likely effect of a cut in rates of income tax on the UK economy Income tax is a direct tax on all incomes received by private individuals after certain allowances are made. A direct tax is a tax whose burden cannot be shifted onto someone else. This is in contrast to an indirect tax. The current structure of the UK income tax is shown below: * Personal allowance: �4,385 per annum * Lower rate 10% * Basic rate 22% * Higher rate 40% Income tax is a progressive tax. This means that as income rises the proportion or percentage of income paid in taxation rises. In the UK the lowest rate of income tax is 10 per cent, the basic rate is 22 per cent and the highest is 40 per cent. Because the marginal rate of tax rises at certain levels of taxable income, the average rate of tax paid also rises with income. Highly paid sports stars will pay most of their earned income at 40%. People in relatively low-paid jobs will pay at most the basic rate of tax. Indeed their gross income may be at a level low enough for them to avoid income tax altogether. ...read more.

Middle

This can be shown in the diagrams below: The flexibility of the economy depends upon either how close the employment level is to full employment, as mentioned above, or the factor mobility. If the labour is not mobile, no matter how far the employment level is from full employment, prices will rise to some extent. Furthermore, if there is a cut in income tax, the marginal propensity to tax in the economy is reduced. We know that the multiplier is calculated by using the following formula: So if the income tax rates are reduced, due to taxation being a leakage from the circular flow, the marginal propensity to leak is reduced, causing the multiplier to increase in size. This therefore results in any change in withdrawals or injections to have a greater effect on income. Therefore, if government increases spending, or investment increases, or any other injection or withdrawal increases, the large multiplier leads to greater changes in employment or greater changes in price. When income tax is cut, the increase in income can have negative effects on the economy. The increased income can lead to increased imports, as the UK has a large marginal propensity to import. Therefore, a large percentage of the increase in disposable income may be leaked out of the economy. ...read more.

Conclusion

This is because, as tax rates fall, there is a greater incentive to work, and so increasing the substitution effect, which is reducing time spent on leisure in order to work more, resulting in longer hours worked, and thus more output produced. A tax cut can also reduce the unemployment trap. The unemployment trap is the situation where the person can earn more by staying at home claiming benefits, than by working. The fall in tax rates would lead to increased in-work disposable incomes relative to out-of work incomes. Therefore, more people would be encouraged to find employment, also resulting in more output as increased employment leads to increased production. Furthermore, as resources are shifted from the inefficient Black economy, to the more efficient legal labour market (Guttmann), productivity increases, resulting an increase in output. The Black economy is considered inefficient due to people in it having to work outside the law, making it difficult to work with transparency and having the need to cover and conceal all work. Hence, tax cuts would lead more people out of the Black economy, and into the legitimate employment. Therefore, tax cuts have both demand-side and supply-side effects on the economy. Incomes, output and prices are likely to rise and any inflationary impact being determined primarily by the level of employment in the economy. ...read more.

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