The amount of tax paid as a percentage of the tax base (typically income).
An average tax rate is the amount taken in tax as a percentage of the tax base. Typically, the tax base will be income, such that the average tax rate is calculated as the tax bill divided by income.
For example, suppose that a person has a before-tax income of £25,000 and pays £2,500 in income tax. That person’s average rate of income tax is 10% (£2,500 ÷ £25,000 = 0.10). This is distinct from the marginal tax rate, which describes the amount of tax payable on an additional £1 of income.
For taxes that are not based on income, the average tax rate is calculated relative to the relevant tax base. For example, for capital gains tax, inheritance tax or council tax, the average tax rate is the amount of tax payable as a share of capital gains, estate value or property value respectively.
The use of lawful means to pay less tax, particularly where contrary to the clear intention of parliament.
Tax avoidance is the use of lawful means to pay less tax. It is distinct from evasion, which is illegal. While tax evasion is a matter of enforcing the law, avoidance is a matter of defining the tax base – that is, the definition of what is taxable, which may leave scope to shift activities into less highly taxed forms.
There are many perfectly reasonable ways that people can reduce their tax bills: for example, by saving in an ISA or pension rather than an ordinary bank account. What marks out avoidance is, in HMRC’s words, ‘bending the rules of the tax system to gain a tax advantage that Parliament never intended’. In practice, determining what counts as avoidance is difficult and often subjective, in part because it is not always clear what parliament intended (or would have intended in a new scenario). For example, people who work through their own companies can usually pay less tax if they pay themselves mostly in dividends rather than through a salary. Parliament explicitly set dividend taxes below taxes on employment income. But it is not clear whether parliament intended for most company owner-managers to minimise their tax bills by taking most of their income in the form of dividends. Some would describe this as reasonable tax planning and others as tax avoidance. In recent years, there has been an increasing tendency to describe particularly contrived forms of tax avoidance as ‘aggressive’ or ‘abusive’ avoidance.
Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain and Sweden.
The EU14 refers to the current European Union member states whose membership of the EU predates 1 May 2004.
Illegally failing to pay one’s full tax liability.
Tax evasion is the use of illegal means to pay less tax – making a false declaration on a tax return, for example – as distinct from avoidance, which is legal (though still sometimes considered ‘abusive’). If uncovered, evasion can be punished through fines or imprisonment; how much evasion succeeds is essentially a function of how successful enforcement is.
A club of developed economies: Canada, France, Germany, Italy, Japan, UK, US.
Gross domestic product (GDP) is a common measure of the size of an economy. It is the total monetary value of all market production undertaken in a particular area (usually a country) in a given period (usually a year).
GDP is the total amount of ‘value added’ in an economy in a particular period of time. (Most commonly, GDP is calculated for a specific country and in reference to a specific year – e.g. the UK in 2021–22.) ‘Value added’ means the monetary value of all goods and services that have been produced (e.g. by companies and individuals in the UK in 2021–22) minus the value of the goods and services used to produce them. For example, if a company makes steel cutlery in the UK, the value added is the amount for which it sells the cutlery minus the amount it paid for inputs, such as raw steel.
Equivalently, GDP measures the total income generated by production (in a particular area in a given time period), as reflected in the total compensation workers receive plus the total operating surplus of companies (which is roughly sales minus costs). This is equivalent to value added because all value added will be either paid to workers or reflected in the profits of companies.
GDP is not a measure of the total stock of wealth in a country, but a measure of the flow of income generated in a country in a given year (or other period).
GDP includes the estimated value of services that are provided by the government but have no associated market price (such as defence, education and health services). Non-market production, including, for example, unpaid housework and childcare, is not included in measured GDP.
The ‘gross’ in ‘gross domestic product’ is a reference to the fact that GDP is measured gross of depreciation. That is, the depreciation (including as a result of ‘wear and tear’) that happens to capital assets (such as machines) is not deducted when calculating GDP. To continue the example above, if the company’s cutlery-making machine depreciates over the year (such that it would require some maintenance to make it as productive as it was at the start of the year), this depreciation cost is not deducted when calculating GDP.
Her Majesty’s Revenue and Customs (HMRC) is the UK government body responsible for the collection and administration of most taxes.
The economic incidence of a tax describes which people are ultimately made worse off by the tax (and can be different from those who are legally liable to pay the tax).
Tax scholars distinguish the legal (or statutory or formal) incidence of a tax, which says who is legally liable to pay it, from its economic (or effective) incidence, which says who is ultimately made worse off by it. The two are often different: for example, VAT is levied on the firms making sales, but few doubt that in practice much of the tax is passed on to customers in higher prices.
In the long run, the formal incidence of a tax should be irrelevant to its economic incidence. Buyers care about the total amount they must pay, sellers about the amount they receive – irrespective of how much is made up of tax. (Note that employers can be thought of as buyers of workers’ time and employees as sellers of work.) So if a tax is formally levied on the seller rather than the buyer, we would expect the price (or wage) to be correspondingly higher so that buyers pay, and sellers receive, the same overall amounts as if the tax had been levied on the buyer instead. In the short run, however, the legal incidence of a tax can matter. If a tax changes, the legal incidence determines who pays the tax on the day after the change and it can take time for prices and wages – the mechanisms by which economic incidence is passed on – to adjust.
Since the formal incidence of a tax should not (in the long run) affect its economic incidence, it can be chosen to minimise administrative costs, and for that reason many taxes are formally incident on firms. But the economic incidence can never be on firms. Firms are legal entities, not real people who can be made better or worse off. The ultimate burden must be felt by firms’ owners, employees or customers (through lower profits, lower wages or higher prices) or some combination. The idea of businesses paying their ‘fair share’ of tax is therefore difficult to make sense of without investigating which people are ultimately paying it.
In practice, the incidence of taxes is usually shared rather than falling entirely on one party. As a rule, it will fall more on those less able to substitute other things for the taxed activity.
Inflation is the change in prices for goods and services over time.
The amount of additional tax due as a percentage of each additional £1 of a tax base (such as income).
A marginal tax rate is the additional amount taken in tax as a percentage of each additional £1 of the tax base. Typically, the tax base will be income, such that the marginal tax rate is the proportion of an additional £1 of income that is taken in tax.
For example, suppose that a person has a before-tax income of £25,000. At this point, they face the basic rate of income tax. This means that if they earn another £1, it will be taxed at a rate of 20% – their marginal tax rate is 20%. This is distinct from the average tax rate, which describes the total amount of tax paid (on the whole £25,000 and not only on an additional £1) as a share of total income.
For taxes that are not based on income, the marginal tax rate is calculated relative to the relevant tax base. For example, for VAT, capital gains tax or inheritance tax, the marginal tax rate is the additional tax payable per £1 of additional spending, capital gains or estate value respectively.
The Organisation for Economic Co-operation and Development (OECD) is an international body representing 38 mostly rich countries.
The current members of the OECD are Australia, Austria, Belgium, Canada, Chile, Colombia, Costa Rica, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, (South) Korea, Latvia, Lithuania, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, the Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
A tax is progressive if tax liability increases more than in proportion to the tax base, or to income.
A tax rate schedule is progressive (as opposed to proportional or regressive) if the average tax rate rises with the tax base. For example, an income tax schedule is progressive if those with higher taxable incomes pay a bigger share of taxable income in tax. A property tax schedule is progressive if the tax is a higher percentage of property value for higher-value properties.
Note that progressivity involves rising average tax rates, not necessarily rising marginal tax rates. It is quite possible to see a fall in the marginal rate within a progressive tax schedule, and indeed the UK has several examples of this. A tax rate schedule will be progressive if and only if the marginal tax rate exceeds the average tax rate, so that an extra £1 of income is taxed at a higher rate than existing income.
Assessing whether a tax is progressive overall is different from assessing whether the rate schedule of a tax is progressive. An overall assessment requires considering who actually pays different amounts of the tax, which will depend on the tax base and the economy as well as on tax rates. When assessing whether a tax is progressive overall, usage of the term progressive varies. It can be used to mean that tax liability rises more than in proportion to: (i) the specific tax base; (ii) a broader notion of the relevant tax base; or (iii) income.
Progressivity is often discussed in respect of income tax, where these distinctions don’t matter much because income essentially is the tax base. In principle, it is possible that income tax could be progressive with respect to taxable income but not with respect to total income, if the kinds of income that rich people receive were exempt from tax; but the UK is far from such a situation in practice.
For other taxes, the distinctions between the three options set out above are more important.
For a tax on a specific good such as beer, for example, whether tax payments are more than proportional to spending on beer, to total spending or to total income are clearly three very different questions.
A tax on business might have a progressive rate schedule (the result of a small profits rate of corporation tax, for example), but whether it is progressive with respect to the incomes of the people who ultimately bear the burden of the tax is a more complicated question, which requires first assessing the economic incidence of the tax.
When progressivity is assessed relative to income, there is also a question of what time horizon to use. It is common to use current income, but lifetime income can be more appropriate. For example, VAT looks regressive as a percentage of current income, because at any given point in time, low-income households typically spend a lot (and therefore pay a lot of VAT) relative to their incomes. But households cannot spend more than their income indefinitely. Over a lifetime, income and expenditure must be equal (except for bequests given and received and the possibility of dying in debt); households spending a lot relative to their income at any given point are often those experiencing temporarily low income and either borrowing or running down their savings to maintain their expenditure at a level more befitting their lifetime resources. VAT paid over a lifetime is roughly proportional to lifetime income/expenditure – indeed, slightly progressive, as items subject to zero or reduced rates of VAT are disproportionately consumed by the lifetime-poor. If only snapshot data are available, measuring VAT as a proportion of current expenditure (rather than income) – progressivity with respect to the tax base – gives a better guide to its underlying distributional effects.
A tax is proportional if tax liability is a constant fraction of the tax base, or of income: it is neither progressive nor regressive.
See ‘progressive’ for more detail and discussion.
A tax is regressive if tax liability increases less than in proportion to the tax base, or to income.
The definition of regressivity is the converse of the definition of progressivity. In summary, a tax rate schedule is regressive if the average tax rate falls as the tax base rises. Whether a tax is regressive overall will depend on the tax base and the economy as well as on tax rates; in making that assessment, usage of the term regressive varies. It can be used to mean that tax liability rises less than in proportion to: (i) the specific tax base; (ii) a broader notion of the relevant tax base; or (iii) income. See ‘progressive’ for more detail and discussion.