June 15, 2024 

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PIGOUVIAN TAX: A tax on an external cost, such as pollution, designed to use market forces to achieve an efficient allocation of resources. A. C. Pigou, one of the first economists to study the market failure of externalities, is credited with developing this tax system for internalizing costs external to the market. An external cost caused by pollution, for example, can be internalized if polluters pay a tax equal to the value of the external cost.

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Taxes are mandatory payments from members of society to governments. The total tax revenue collected from a specific tax can be identified as the product of the tax rate times the tax base. The tax base can be specified as either a physical quantity or monetary value, giving rise to two types of tax per unit tax (quantity) and ad valorem tax (value). In some cases it is useful to specify a tax rate as an average tax rate and in other cases as a marginal tax rate.
Governments impose a wide range of taxes on a wide range of consumption, production, assets, and exchange activities. While government taxation is exceedingly diverse, it abides by a few basics.

One common basic is that tax revenue can be identified as the product of a tax rate times a corresponding tax base. The tax rate is specified as a percent of the tax base. The tax base can be a range of different activities or assets, including income, wealth, sales, and property. If the tax base is measured as a physical quantity, such as gallons of gasoline, then the tax rate is a per unit tax. If the tax base is measure as a monetary value, such as income, then the tax rate is an ad valorem tax.

A Transfer of Control

Taxes are the primary method used by governments to obtain control over the economy's productive resources, that is, purchasing power. As a general rule people obtain purchasing power and control over resources based on income. Taxes force people to transfer a portion of their incomes and purchasing power to governments. Governments then use this income, this tax revenue, this purchasing power, to finance expenditures and to pay for the provision of public goods.

To be specific taxes are mandatory, involuntary, or coerced, payments to governments. The "involuntary" part means that those who pay taxes don't have a choice. Either pay the taxes or suffer the punishment. The "payment" part generally takes the form of a "monetary" payment, but it also could be an "in-kind" payment, that is, a good, service, or resource.

Base and Rate

In much the same way that total revenue received for selling a good is the product of price and quantity, the revenue collected from a specific tax is the product of a tax base and a tax rate. A tax base is simply an item or activity that is subject to taxation. A tax rate is then the percent of the tax base that is collected as tax.
tax=tax basextax rate
A common tax base is income. An income tax rate is then the percentage of income paid in tax. Suppose, for example, that Jonathan McJohnson, a junior executive at OmniConglomerate, Inc., earns $50,000. If the income tax rate is 10 percent, then he pays 10 percent of his income, $5,000, in income taxes. The tax paid is the tax base times the tax rate.
income tax=$50,000x10%=$5,000

What to Tax: Many Bases

The need to collect taxes combined with the reluctance to pay taxes (or at least have "someone else" pay taxes) has prompted governments to identify a number of different tax bases. Tax bases are invariably an asset or activity. A few of the more important tax bases are:
  • Income: At the top of the list of tax bases is income generated from productive activity. Taxes levied on income includes the ever-popular personal income tax that people are required to pay every April 15th, the corporate income tax on the profit earned by corporations, and the Social Security tax (the FICA payroll deduction) on wage earnings.

  • Wealth: Physical and financial assets are another favorite tax base of governments. The two most noted wealth taxes are property taxes paid by homeowners and estate or inheritance taxes paid on wealth passed down from one generation to the next.

  • Consumption: A third common tax base is consumption. Sales taxes are unquestionable the most common tax on consumption. However, a number of specific consumption activities are also subject to taxation, taking the form of fuel taxes, liquor taxes, cigarette taxes, college tuition, public park entrance fees, drivers license fees, telephone usage taxes, and... well... the list goes on and on.

Per Unit and Ad Valorem Taxes

The tax base for many taxes is specified as a dollar value (such as income), while the tax base for other taxes is specified in physical units (gallons of gasoline). This difference highlights two types of taxes -- ad valorem and per unit.
  • Ad Valorem Tax: An ad valorem tax is a tax specified as a percentage of the price or value of a good, service, asset, or other activity. Ad valorem taxes tend to be broad based, imposed on activities such as income and retail sales. In fact, the two most important ad valorem taxes are income taxes and sales taxes. People pay a percentage of their incomes in income taxes or a percentage or the value of their purchases in sales taxes, regardless of the amount of time spent working or the quantities of goods purchases.

  • Per Unit Tax: A per unit tax is a tax specified as a percentage of the quantity of a good, service, asset, or other activity. Per unit taxes are often imposed on specific goods or markets. A common per unit tax is that levied on gasoline. People pay a given tax for each gallon of gasoline purchased, regardless of the price of gasoline.

Average and Marginal Rates

Like many economic concepts (cost, revenue, product, and consumption), tax rates can be specified as either average or marginal, as either a proportion of the overall tax base or as an incremental change in the tax base.
  • Average Tax Rate: An average tax rate is the percentage of the total tax base paid in taxes. For example, if Duncan Thurly earns $50,000 in income and pays $5,000 in taxes, then his average income tax rate is 10 percent.

  • Marginal Tax Rate: A marginal tax rate is the percentage of an incremental change in the tax base paid in taxes. For example, if Duncan Thurly has a $10,000 increase in earnings from $40,000 to $50,000 and his income taxes increase by $2,000 from $3,000 to $5,000 in taxes, then his marginal income tax rate is 20 percent.
If the tax rate does not change as the tax base increases, then average and marginal tax rates are the same. However, if the tax rate changes as the base increases, then the two are not the same. Marginal tax rates are particularly important in the measurement of tax proportionality. If the marginal tax rate increases with more income, then the tax is progressive. If the marginal tax rate decreases with more income, then the tax is regressive.


Recommended Citation:

TAXATION BASICS, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2024. [Accessed: June 15, 2024].

Check Out These Related Terms...

     | taxation principles | tax effects | revenue effect | allocation effect | tax equity | ability-to-pay principle | benefit principle | horizontal equity | vertical equity | tax proportionality | proportional tax | progressive tax | regressive tax | tax efficiency | tax incidence | tax wedge | deadweight loss |

Or For A Little Background...

     | taxes | government functions | efficiency | equity | distribution standards | public finance | allocation |

And For Further Study...

     | public choice | good types | market failures | public goods: demand | public goods: efficiency | tax multiplier | personal tax and nontax payments | transfer payments |

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