What is Tax?

Tax Meaning

Taxes are required payments to a general government made by people and corporations. Taxes are the government's primary sources of income and are predicted to be £732 billion from 2021-2022. Income tax, National Insurance contributions, and VAT account for 60% of the total UK tax revenue.

Taxes are essential to finance government activities, such as public works and services, including schools, public health services and public infrastructures. Various taxes exist, varying from income tax to capital gains taxes.

Taxes Explained with Examples

Taxes are the government's primary source of income and help fund public works, services, and infrastructures. It includes transportation, water, electricity, sewage, schools, roads, pensions and public health services. Taxes also promote the redistribution of income and wealth.

They apply to people and corporations following tax law and government guidelines on the money they receive. The amount of taxes collected by the state varies from year to year. Any variations in taxes collected can increase or decrease the government's revenues and reduce or increase their public spending ability.

According to the office for Budget and responsibility, the UK revenue for 2021-2022 is forecast to be £819 billion. £732 billion will come from taxation alone. Income tax, National Insurance contributions, and VAT account for 60% of the total tax revenue.

Not every person and corporation pays the same amount of taxes. The amount varies depending on income, properties and investments owned, etc. Most taxes are collected in the UK by the central government in Westminster and are then spread across the country. The local government collects some taxes in Scotland, Wales and Northern Ireland.

Any failure to pay a tax is punishable by law. Similarly, attempts to limit or reduce the amount of taxes paid, notably through tax evasion, are prohibited under tax law.

How Taxes Work

Types of taxes and tax incentives

A tax can be collected either directly or indirectly. A direct tax is imposed upon a person or property. An indirect tax is levied upon a transaction. Tax systems vary significantly among countries.

Income tax

The income tax is the percentage of generated income paid to the state, including salaries, jobseeker's allowance, income from property, etc. Most countries adopted a progressive income tax, which means that a higher percentage is collected from high-income individuals and corporations.

In the UK, people must pay income tax if they earn more than £12,570 per year. The tax rate varies from 0% to 45%, depending on the income and applicable tax band. The tax rate also varies in England, Scotland, and Wales.

The income tax can also vary depending on whether the taxpayer is married or single. The source of the income can also make a difference in taxation.

National insurance contribution

National insurance contributions are mandatory for individuals earning more than £184 a week. It represents a percentage of the generated income that is collected by the state to finance the benefits system and the pensions. Different types of National Insurance classes exist, influencing the amount paid and the benefits and state pension a taxpayer can receive.

Capital gain tax

The Capital gains tax is a tax on the profit made when an asset increases in value and is sold. If a taxpayer buys a property or an asset for £1000 and sells it for £5000, the profit will be subject to the capital gain tax.

The capital gain taxes are particularly of interest for taxpayers that own properties and assets and for investors. Profits made by investments are subject to taxes. Profits made from selling shares are taxed if they exceed £12,300. Similarly, gains generated from dividends are also subject to income tax.

This category also includes Inheritance Tax, usually paid by the estate of the person who's died. It is important to note that capital gain taxes only apply if the asset sold has increased in value. If it is sold at a loss, no tax is applicable.

Similarly, other legal ways exist to limit the amount of capital gain tax paid. If money is invested through a Lifetime ISA, any profits generated through an ISA are tax-free up to £20 000.

Corporate taxes

Businesses are subject to capital gain taxes when they dispose of an asset and generate a profit. The tax is paid on the company's taxable income. If a company does not create a profit within the tax year, they are not subject to corporate tax. The average corporation tax in the UK is 19%.

Some Companies are subject to a different tax regime depending on their industry. Oil and gas companies can be subject to a 30% income tax.

VAT

VAT (Value-added tax) is a tax collected on a product at every stage of its production. The amount of VAT paid by the customer depends on the applicable VAT rate and the product's cost. In the UK, the standard rate is 20%; it can be reduced for some goods and services or increased.

The VAT is an indirect tax collected by the seller (company) and then paid to the government. It is on the few regressive taxes, as the portion paid tends to decrease as income rises.

​​Other types of taxes

Other taxes exist but represent a smaller portion of the government's income. In the UK, taxpayers must pay the council tax to their local council. Council tax is a property-based tax that covers the services provided by their local authority, such as bin collection, sewage, libraries, social care, etc. It is calculated based on the value of the property where the taxpayer lives.

Taxpayers also need to pay taxes when they buy or sell their home: Stamp Duty Land for properties brought in England, Land Transition Tax for those in Wales.

The power of tax incentives

As mentioned, taxes are an important source of income for governments and are essential to finance their public expenditure. Basic public services would not receive funding without the tax system. Taxes are also a vital tool government uses to attract companies.

By lowering corporate taxes, governments can attract companies that seek. Tax incentives related to investment can also attract investors to the country. For example, capital tax gain top rate of 19% is low in the UK compared to countries like France, which a top rate of 45%. The government can put other schemes and tax incentives to improve its competitiveness and attractiveness.

What it means for retail investors

Retail traders need to keep an eye on taxes, especially when it comes to Capital gain tax. Retail investors will need to pay this after making a certain amount. Taxes need to be paid. Otherwise, it will be punishable by law.

References

- HM Revenue & Custom, Guidance: Rates and allowances for Corporation tax, updated on April 1st. "https://www.gov.uk/government/publications/rates-and-allowances-corporation-tax/rates-and-allowances-corporation-tax." Accessed Aug. 09,2022.

- VAT Rates, Gov.UK. "https://www.gov.uk/vat-rates." Accessed Aug. 09, 2022.

- The Regressivity of a Value Added Tax: Tax Credit method and subtraction method – A Japanese case. "https://ifs.org.uk/fs/articles/tamaoka_may94.pdf." Vol. 15, no. 2, pp57-73. Accessed Aug. 09, 2022

- Buying or Selling your Home, Gov.uk. "https://www.gov.uk/buy-sell-your-home/tax." Accessed Aug. 09, 2022.

- Institute for Government, Tax and devolution, published on November 25, 2020. "https://www.instituteforgovernment.org.uk/explainers/tax-and-devolution." Accessed Aug.09, 2022.

- Waters T. Pope, T, A survey of the UK tax system, Institute for Fiscal Studies, November 2016. "https://ifs.org.uk/bns/bn09.pdf." Accessed Aug. 09, 2022.

- Seely A., Research Briefing: Direct taxes: rates and allowances, public on April 6th, 2021, UK parliament. "https://commonslibrary.parliament.uk/research-briefings/cbp-9146/." Accessed Aug. 09, 2022.

- Income Tax rates and Personal Allowances, Gov.uk."https://www.gov.uk/income-tax-rates." Accessed Aug. 09, 2022.

- Tax when you sell shares, Gov.uk. "https://www.gov.uk/tax-sell-shares." Accessed Aug. 09, 2022.

- Capital Gains Tax, Gov.uk. "https://www.gov.uk/capital-gains-tax/what-you-pay-it-on." Accessed Aug. 09, 2022.

- Lifetime ISA, Gov.uk. "https://www.gov.uk/lifetime-isa." Accessed Aug. 09, 2022.

- UK tax and incentives, Department for International Trade, October 2020. "https//www.great.gov.uk/international/content/about-uk/why-choose-uk/tax-incentives/." Accessed Aug. 09, 2022.