Why to pay taxes

Undoubtedly, the Government requires ‘revenues’ in order to fund the Public sector expenditure. In their book, Parkin & King (1992) argue that Government sector expenditure can be mainly divided into the following four categories: Expenditure on goods and services, Subsidies, Transfer payments and subsidies, and Debt interests.

On the other hand, the main sources of the revenues needed are:

  • Taxes
  • Royalties: Proceeds reserved by the government for permitting other economic agents to exploit and make use of public property.
  • Money creation: An inflation tax
  • Borrowing: From individuals, firms, and institutions (domestic or abroad)
  • Profits and interest: On government run business and loans made by other governments.
  • National insurance contributions: Amount paid by the employers to the public in order to insure themselves through the government against possible illness, unemployment, and retirement.

 Although, we will appreciate the aforementioned alternative ways through which public expenditure can be funded, taxation is the main source of income.

Depending on which of the aforementioned figures (revenues and expenditure) is the greater we can define the financial surplus as when revenue exceeds expenditure and the financial deficit as when expenditure exceeds the income. The surplus or deficit is usually presented as a percentage to the GDP.

Tax Base - direct and indirect taxes

Depending on the specific time and from the particular ideology of each country, taxes are levied either on income and / or on expenditure.

Taxes on income, include :

(Direct taxes)

  • The personal income tax: The sum of income from various sources is calculated and then taxed in total
  • The corporation tax: Mostly is a percentage on company profits
  • Taxes on Capital: Taxes on property, Capital gain taxes, etc

Taxes on expentiture, include :

(Indirect taxes)

  • Value added tax (VAT)
  • Taxes on tobacco, alcohol, and petrol.

One of the traditional criteria used for the classification of taxes as direct and indirect has been the ability of shifting the tax to another person. In practice we can consider as direct taxes those on income and property and those on expenditure as indirect.

It can be argued that developed counties are mainly based upon direct taxes, i.e. individual and corporate taxation. On the contrary, the developing countries are based mostly on indirect taxes, i.e. VAT.

Tax rates and tax income

It can be argued that in the short run, an increase on income tax rates (up to a specific point) will in turn increase the government’s revenues and as a consequence reduce the financial deficit [1]

However, should continue the increase of tax rates after a specific point, the tax revenues will start to decrease   due to the substitution effect.[2]

The above is illustrated by the Laffer[3] curve, which draws the relationship between income tax and taxation rate.

Laffer suggested that as the tax rate increases , the tax income increases as well , but up to a maximum point (A) that represents the optimum tax rate where the maximum amount of tax income could be collected. After the specific point, should continue the tax rate to increase , the tax revenue will start decreasing . In other words, we have the emergence of the substitution effect. A lack of incentives would lead to a fall in income and therefore a fall in income tax. The end – point is undoubtedly a tax rate of 100 %, where no one would be willing to work and so income tax would reach the zero point.

How tax incentives influence investments

The private investment behaviour is primarily influenced by the maximization of the profit. In other words, when carrying out an appraisal of a prospective investment, the extent of corporate tax, on net profits, is of major importance. . Thus ‘pure’ net profit although reduces the income shown on financial statements, sounds welcomed when a firm considers payable taxes.

To this regard, it would be to the firm’s benefit should allowed by the tax legislation to deduct the maximum cost items and consequently to ‘present’ the minimal taxable income.

Specifically, some items that influence the investment through taxation could be the following:

  • Accelerated depreciation

Allows the firm to a faster write-off of its assets and as a consequence reduces the taxable income.

  • Various tax credits.

For those firms that will be activated into specific sectors of the economy or   regions of the country that deem significant for national economic policy.

  • Reduced cost of capital

For example, the amount of taxable interest or lease payments.


Assignment (abstract), Public Finance, Manolis Sp. Anastopoulos, University of Leicester.

[1]In the long run, a high tax rate is without doubt a disincentive for investment – savings that most probably will lead to an increase of financial deficit

[2] Individuals due to their reduced disposal income will start to substitute leisure time for additional income since they will be unwilling to work harder than before

[3] Dr. Arthur Laffer was an advisor to President Reagan of USA in the early 1980s but despite that, he become quite well known through his ‘curve’ Time magazine included him among ‘The Century’s Greatest Minds’ (Greater Talent Network Inc, 1999-2002)

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