Introduction
Every day, we use services that we do not pay for directly.
We drive on public roads, walk along pavements, rely on street lighting, expect the police to respond in an emergency and trust that hospitals, schools, courts and the armed forces will be there when they are needed.
Most of us never receive a bill for these services.
So who pays for them?
The answer is that they are funded largely through taxation.
Taxes are one of the oldest and most important features of organised society. Almost every modern country collects taxes to fund public services, maintain infrastructure, protect its citizens and support those who need help.
Without taxation, governments would have very little money with which to operate.
In the previous chapters, we explored how the UK Government prepares its Budget, where government money comes from, how it is spent, what happens when spending exceeds income and how governments borrow when they need additional funds.
We have seen that taxes are the government’s largest source of income.
This chapter explores taxation itself.
It explains why governments collect taxes, why there are many different types of tax, how the tax system works and why taxation lies at the heart of almost every political and economic debate.
The following chapters will then examine the UK’s main taxes individually, beginning with Income Tax, before moving on to National Insurance, VAT and Corporation Tax.
The One Big Idea
Taxes are how society pools resources to pay for things that individuals usually cannot provide alone.
Every person, business and organisation benefits from living in a society with roads, schools, hospitals, courts, emergency services and national defence.
Rather than asking people to pay separately every time they use these services, governments collect taxes from across society and use that money to fund them collectively.
In this way, millions of individual contributions are combined to support services that benefit the country as a whole.
A tax system is therefore much more than a way of raising money.
It is one of the foundations on which modern society operates.
What Is a Tax?
A tax is a compulsory payment collected by the government from individuals, businesses or organisations.
Unlike a voluntary donation or a payment for a specific service, taxes are required by law.
The money collected is used to help fund public spending and provide services that benefit society.
Different taxes are collected in different ways.
Some are paid when people earn an income.
Others are paid when goods and services are purchased.
Some are paid by businesses, while others are linked to owning property or making certain transactions.
Together, these taxes provide most of the government’s revenue.
Although people sometimes think of taxation simply as money leaving their pay packet or being added to the price of goods, taxes perform a much broader role.
They provide the financial resources that allow governments to operate.
Without taxation, it would be difficult to maintain many of the services that people rely upon every day, from education and healthcare to policing, transport infrastructure and environmental protection.
Why Governments Collect Taxes
The most obvious reason governments collect taxes is to raise the money needed to fund public services.
As we saw in Where Government Money Goes, governments spend money on a wide range of activities.
These include:
- healthcare;
- education;
- defence;
- policing and the justice system;
- transport infrastructure;
- welfare and pensions;
- environmental protection;
- scientific research; and
- local government services.
Most of these services could not easily be organised or funded by individuals acting alone.
Imagine if every household had to pay separately for each mile of road they used, every visit from the fire service or every police investigation. The system would be complicated, expensive and, in many cases, impractical.
Taxation allows society to pool resources so that essential services can be planned, funded and made available to everyone.
Taxes also help governments invest in the future.
Major projects such as new railways, flood defences, renewable energy infrastructure and hospitals often require substantial investment over many years. Tax revenue provides much of the funding needed to make these projects possible.
In this sense, taxation is not simply about paying for today’s public services. It also helps finance the long-term investments that support future generations.
Why Are There So Many Different Taxes?
If taxes are simply a way of raising money, why doesn’t the government collect just one tax?
The answer is that modern economies are complex.
People earn income in different ways, spend money on different goods and services, own different types of property and operate different kinds of businesses.
No single tax could raise enough revenue fairly and efficiently from every part of the economy.
Instead, governments use a combination of taxes.
Some are linked to income, others to spending, others to business profits and others to specific activities such as buying property or consuming products like fuel, tobacco or alcohol.
Using several different taxes also makes government revenue more stable.
If one source of tax income falls during an economic downturn, other taxes may continue to provide revenue. This reduces the government’s dependence on any single source of income.
An everyday analogy may help.
Imagine a football team that relied entirely on one player to score every goal.
If that player became injured, the team’s performance would suffer dramatically.
A successful team relies on contributions from many different players.
The UK’s tax system works in much the same way.
Rather than relying on one tax alone, the government raises revenue from a variety of sources. Together, these taxes provide a more balanced and resilient system for funding public services.
Direct Taxes and Indirect Taxes
Although there are many different taxes in the UK, they can be grouped into two broad categories:
- direct taxes; and
- indirect taxes.
Understanding the difference between these two types of tax makes it much easier to understand how the UK tax system works.
Direct Taxes
A direct tax is paid directly by the person or organisation on whom the tax is charged.
In other words, the person who is legally responsible for paying the tax is also the person who bears its cost.
Examples of direct taxes include:
- Income Tax;
- Corporation Tax;
- Capital Gains Tax; and
- Inheritance Tax.
For example, if you earn a salary, Income Tax is deducted from your earnings. If a company makes a profit, it may pay Corporation Tax on those profits.
Direct taxes are often linked to a person’s income, wealth or profits rather than what they choose to buy.
Because of this, governments can adjust direct taxes in different ways to achieve different policy objectives. For example, people with higher incomes may pay more Income Tax than those with lower incomes, while companies pay Corporation Tax only if they make taxable profits.
The detailed rules for each of these taxes vary considerably, but the underlying principle is the same: the tax is charged directly on the individual or organisation.
The following chapters will explore the UK’s main direct taxes in much greater detail.
Indirect Taxes
An indirect tax is collected when people buy goods or services.
Unlike a direct tax, the tax is usually collected by a business and then passed on to the government.
Examples include:
- Value Added Tax (VAT);
- Fuel Duty;
- Alcohol Duty;
- Tobacco Duty; and
- Air Passenger Duty.
When you buy most everyday products in a shop, part of the price you pay may include VAT. The retailer collects this tax and later pays it to the government through HM Revenue & Customs (HMRC).
Although businesses are responsible for collecting many indirect taxes, it is usually the customer who ultimately bears the cost because the tax is included in the purchase price.
This is why indirect taxes are sometimes described as taxes on spending rather than income.
Why Use Both Types of Tax?
If governments already collect Income Tax, why do they also collect VAT and many other taxes?
The answer is that different taxes raise revenue in different ways.
Some taxes are linked to earning money.
Others are linked to spending money.
Others are linked to business profits, owning property or particular activities.
Using a mixture of taxes helps create a broader and more stable source of government revenue.
For example, during an economic slowdown, Income Tax receipts may fall because fewer people are working or wages are growing more slowly. However, people will usually continue buying food, fuel and many everyday goods, meaning that some indirect tax revenues continue to flow into the Treasury.
Similarly, if consumer spending falls sharply, taxes on income and business profits may still provide significant government revenue.
No single tax can perform every role.
Instead, the different taxes work together to fund public services and support the government’s finances.
Who Collects Taxes?
Taxes are collected on behalf of the UK Government by HM Revenue & Customs (HMRC).
HMRC is the government department responsible for administering the UK’s tax system.
Its responsibilities include:
- collecting taxes;
- administering National Insurance contributions;
- collecting certain duties, such as Alcohol Duty and Tobacco Duty;
- paying some forms of financial support, such as Child Benefit; and
- helping ensure that tax laws are followed.
Every year, HMRC collects hundreds of billions of pounds that help fund public services across the UK.
Many people interact with HMRC without even realising it.
If you are employed, Income Tax is usually deducted automatically from your salary before you receive it through a system known as Pay As You Earn (PAYE).
If you are self-employed, you normally calculate and report your income yourself through a Self Assessment tax return.
Businesses also play an important role.
Employers deduct Income Tax and National Insurance from employees’ wages before paying them. Shops collect VAT on many purchases. Companies calculate and pay Corporation Tax on their taxable profits.
In many cases, businesses act as intermediaries, collecting taxes on behalf of the government before passing the money to HMRC.
As a result, much of the tax we pay is collected automatically, making the system more efficient than requiring every individual to calculate and pay every tax separately.
What Makes a Good Tax System?
Collecting taxes is only part of the challenge.
Governments also have to decide how taxes should be designed.
There is no perfect tax system, but economists often agree that a good tax system should aim to balance several important objectives.
It Raises Enough Revenue
The first purpose of a tax system is to provide sufficient income to fund public services and allow the government to carry out its responsibilities.
If taxes raise too little money, governments may need to borrow more or reduce spending.
It Is Fair
Most people believe that taxes should be fair.
However, people do not always agree on what fair means.
Some believe everyone should contribute the same proportion of their income.
Others believe those with higher incomes should contribute a larger share.
These questions about fairness will become an important theme later in Fair Society, but for now it is enough to recognise that fairness is one of the central principles considered when designing tax systems.
It Is Simple to Understand
A tax system should be as clear and straightforward as possible.
If taxes become excessively complicated, they become more difficult for individuals and businesses to understand and more expensive for governments to administer.
Although modern tax systems inevitably contain detailed rules, simplicity remains an important goal.
It Supports Economic Activity
Taxes raise money, but they also influence behaviour.
Governments therefore try to design tax systems that raise revenue without unnecessarily discouraging people from working, investing, starting businesses or developing new ideas.
Finding the right balance is often one of the most challenging aspects of tax policy.
It Is Difficult to Avoid
A good tax system should make it difficult for people or businesses to avoid paying taxes unfairly.
If large numbers of taxpayers are able to avoid contributing while continuing to benefit from public services, confidence in the tax system may decline.
For this reason, governments regularly update tax laws to close loopholes and improve compliance.
It Provides Stable and Predictable Revenue
Governments need to plan spending years in advance.
A tax system that produces reasonably stable and predictable revenue makes it easier to prepare budgets and finance public services.
Using a variety of different taxes helps achieve this stability because the government is not relying on a single source of income.
These principles sometimes complement one another, but they can also conflict.
For example, making a tax system fairer may also make it more complicated. Reducing taxes to encourage investment may reduce government revenue in the short term.
Designing a tax system therefore involves balancing a number of competing objectives rather than finding one perfect solution. That is one reason why debates about taxation continue in every modern democracy.
Why Do Tax Debates Exist?
Almost everyone agrees that governments need taxes.
Without tax revenue, it would be impossible to fund public services such as the NHS, schools, policing, defence or transport infrastructure.
Where people often disagree is how the tax system should be designed.
Taxation is not simply an economic question.
It also involves values, priorities and different ideas about what makes a fair society.
For example, people may disagree about questions such as:
- Should taxes be higher or lower?
- Should people with higher incomes pay a greater proportion of their earnings?
- Should businesses pay more tax?
- Should taxes encourage certain behaviours, such as reducing pollution or discouraging smoking?
- Is it better to tax income, spending, wealth or property?
There are rarely simple answers.
Changing one part of the tax system often affects many other parts of the economy. Reducing one tax may encourage investment or increase consumer spending, but it may also reduce the government’s income. Increasing another tax may raise additional revenue but could also influence how people work, save or invest.
These trade-offs explain why taxation remains one of the most debated areas of public policy.
Throughout Fair Society, we will return to many of these questions.
Our aim is not to tell you which tax system is best, but to help you understand the different arguments so that you can form your own informed opinions.
Tax Avoidance and Tax Evasion
People sometimes confuse tax avoidance and tax evasion, but they are very different.
Tax Avoidance
Tax avoidance involves arranging your financial affairs in a way that reduces the amount of tax you legally have to pay.
For example, paying money into a pension or using an Individual Savings Account (ISA) may reduce the amount of tax you owe because these arrangements are specifically allowed by law.
However, some forms of tax avoidance involve exploiting loopholes or complicated financial arrangements that, while technically legal, may go against the spirit of the tax system.
Governments regularly change tax laws to close such loopholes and make the system fairer.
Tax Evasion
Tax evasion is different.
It involves deliberately breaking the law in order to avoid paying tax.
Examples include:
- deliberately failing to declare income;
- keeping false financial records;
- hiding money or assets from HMRC; or
- claiming tax reliefs fraudulently.
Tax evasion is a criminal offence.
HMRC has powers to investigate suspected tax evasion and, where appropriate, impose penalties or prosecute those responsible.
Understanding the difference is important.
Tax avoidance is generally legal, although some forms are controversial.
Tax evasion is illegal.
Taxes Are About More Than Raising Money
Although governments collect taxes primarily to raise revenue, taxation also influences behaviour.
For example, taxes on tobacco and alcohol help raise money for public spending, but they may also discourage excessive consumption because higher prices often reduce demand.
Similarly, environmental taxes can encourage households and businesses to reduce pollution or use energy more efficiently.
This means that taxes sometimes have two purposes:
- raising revenue; and
- encouraging or discouraging particular behaviours.
Exactly how governments should use taxation in this way is often debated.
Some people believe taxes should focus almost entirely on raising revenue.
Others believe taxes can also be used to improve public health, protect the environment or achieve other social objectives.
These debates illustrate once again that taxation is about both economics and public policy.
Looking Back at the Budget
By this point, it is useful to step back and look at the wider picture.
In The UK Budget, we learned that the government prepares an annual financial plan.
We then explored where government money comes from, where it goes, what happens when spending exceeds income and how governments borrow when they need additional funds.
This chapter completes that picture.
Taxes provide the largest source of the government’s income.
Without taxation, governments would be unable to fund most public services or repay the money they have borrowed.
Taxation is therefore not a separate subject from the Budget.
It is one of the foundations on which the entire system of public finance depends.
Understanding taxation helps explain not only how governments raise money, but also why discussions about public spending, borrowing and the economy are so closely connected.
Why Understanding Taxes Matters
Whether we realise it or not, taxation affects almost every aspect of daily life.
It influences how much income people keep after they are paid, how much goods and services cost, how businesses invest and how governments finance public services.
Taxation also shapes many of the biggest debates in politics.
Questions about healthcare, education, pensions, defence, welfare, housing and infrastructure are all linked to one fundamental question:
How should these services be paid for?
Understanding how taxes work provides the knowledge needed to take part in these discussions with confidence.
It also helps us recognise that taxation is rarely about simple right or wrong answers.
Instead, it involves balancing competing priorities, weighing different economic effects and deciding how society wishes to share the costs of the services from which everyone benefits.
That is why taxation lies at the heart of understanding both government finances and modern society.
Common Misunderstandings
Taxes affect almost everyone, yet they are often surrounded by misunderstandings.
Some misconceptions arise because the tax system is complex. Others result from political debate, where different viewpoints are often presented without explaining the underlying principles.
Understanding the following common misunderstandings will help you make better sense of discussions about taxation.
“Taxes Only Pay for Welfare”
This is one of the most common misconceptions.
In reality, welfare is only one part of government spending.
Tax revenue helps fund a wide range of public services, including:
- the NHS;
- schools and universities;
- policing and the courts;
- the armed forces;
- roads and railways;
- local councils;
- environmental protection;
- scientific research; and
- pensions and welfare benefits.
Every pound of tax collected contributes towards the overall Budget rather than being assigned to one specific service.
When you pay Income Tax or VAT, your money is not placed into a separate account labelled “healthcare” or “education.” Instead, all government revenue is combined to help finance the full range of public spending approved through the Budget.
“Only People Who Pay Income Tax Pay Taxes”
Another common misunderstanding is that only people who pay Income Tax contribute towards government revenue.
In reality, almost everyone pays some form of tax.
For example:
- shoppers pay VAT on many purchases;
- motorists pay Fuel Duty;
- people buying alcohol or tobacco pay excise duties;
- homeowners may pay Council Tax through their local authority; and
- businesses pay taxes such as Corporation Tax.
Even someone who earns too little to pay Income Tax will usually pay other taxes during everyday life.
This is one reason governments use a variety of different taxes rather than relying on a single source of revenue.
“Businesses Pay Taxes, Not People”
Businesses certainly pay taxes such as Corporation Tax, Business Rates and employers’ National Insurance contributions.
However, economists often point out that the cost of business taxes is ultimately borne by people in different ways.
A company might respond to higher taxes by:
- reducing profits paid to shareholders;
- increasing prices for customers;
- paying lower wages than it otherwise could; or
- investing less in future growth.
Exactly who bears the cost depends on the circumstances.
This illustrates an important economic principle:
Although governments collect taxes from businesses, the economic effects are often shared between businesses, workers, customers and investors.
“Higher Taxes Always Mean More Government Revenue”
It might seem obvious that increasing tax rates will always increase the amount of money collected.
In practice, the relationship is not always that simple.
If taxes become significantly higher, some people may work fewer hours, businesses may invest less, consumers may spend differently or individuals may seek legal ways to reduce the amount of tax they pay.
Conversely, reducing some taxes may encourage greater economic activity, which can increase tax revenues in other parts of the economy.
This does not mean that lower taxes always increase government revenue, nor that higher taxes always reduce it.
Instead, economists recognise that tax policy often involves finding a balance between raising revenue, encouraging economic activity and maintaining fairness.
“Governments Could Simply Print More Money Instead”
People sometimes ask why governments need taxes at all.
Why not simply create more money whenever additional spending is needed?
Although this may sound like an easy solution, creating money without a corresponding increase in the production of goods and services can contribute to inflation, reducing the purchasing power of money across the economy.
Modern governments therefore rely primarily on taxation and borrowing to finance public spending.
We will explore money creation, inflation and the role of the Bank of England later in the Understanding Societysection.
For now, the important point is that taxation remains the principal source of government revenue.
Conclusion
Taxes are one of the foundations of modern society.
They provide the money that enables governments to fund public services, invest in infrastructure, support those in need and carry out the many responsibilities expected of a modern state.
Although there are many different taxes, they all contribute towards the same overall goal: providing the resources needed for government to operate.
This chapter has shown that taxation is about much more than simply collecting money.
A well-designed tax system aims to raise sufficient revenue while remaining fair, efficient, understandable and supportive of a healthy economy. Achieving all of these objectives at the same time is not always easy, which is why taxation remains one of the most debated areas of public policy.
Understanding how taxes work also helps us understand many wider questions.
How should public services be funded?
How should the costs of society be shared?
How can governments encourage economic growth while raising enough revenue to meet public needs?
These are important questions that do not have simple answers.
The aim of this chapter has not been to tell you what the UK’s tax system should look like, but to provide the knowledge needed to understand how it works and why taxation lies at the heart of government, economics and society.
Continue Learning
You now understand the principles that underpin the UK’s tax system.
You know:
- why governments collect taxes;
- why there are different kinds of taxes;
- the difference between direct and indirect taxes;
- the role of HM Revenue & Customs (HMRC);
- what makes a good tax system; and
- why taxation is one of the most important and widely debated aspects of public policy.
The next four chapters examine the UK’s largest taxes in greater detail.
We begin with Income Tax Explained, which explores how tax is charged on earnings, why different tax bands exist and how Income Tax contributes to funding public services.
After that, we’ll look at:
- National Insurance Explained;
- VAT Explained; and
- Corporation Tax Explained.
Together, these chapters will complete your understanding of how the UK raises most of the money that funds government spending.
Once the taxation section is complete, we’ll move beyond public finances and begin exploring the wider economy, starting with What Is GDP?—the first step in understanding how a country’s economic performance shapes living standards, government finances and society as a whole.