Understanding taxation systems and how they support public sector budgets

Public services and social welfare are among the most essential components of any modern society. But these services require funding, and this funding typically comes from taxation – the lifeblood of a nation’s public sector budgets.

Understanding the intricacies of taxation systems and public sector spending is important for anyone working in – or with – the public sector because of their far-reaching implications. For example, they influence:

policy-making
economic stability
citizen well-being

In the United Kingdom – along with the majority of other nations – they support a comprehensive range of services, from healthcare and education to infrastructure and defence.

Taxation in the United Kingdom

The UK government relies on a variety of taxation sources to generate revenue for funding public services and other government activities.

These sources can be broadly categorised into direct and indirect taxes:

Direct taxes are the taxes on people’s income or wealth.
Indirect taxes are the taxes people pay when purchasing certain goods and services.

What are the main sources of tax revenue for the government?

For the UK government, the main sources of government tax revenue include:

Income Tax. Income Tax in the UK is a progressive tax system, which means that higher earners pay a larger portion of their income through a higher rate of tax. Income taxpayers typically have their taxes deducted directly from their earnings – known as Pay As You Earn, or PAYE. Some people, such as those who are self-employed, can pay their taxes through a self-assessment process at the end of each tax year.
Value Added Tax (VAT). VAT, an indirect tax, is added to most goods and services at the point of purchase and is paid by both individuals and businesses.
Corporation Tax. Private sector businesses in the UK – including foreign companies with offices or branches in the UK – are required to pay Corporation Tax on their profits.
National Insurance. National Insurance contributions help fund the National Health Service (NHS) and other social security programmes, such as state pensions and statutory maternity pay.

Other examples of tax liabilities and accruals in the UK include:

The Stamp Duty Land Tax, which is paid by people purchasing homes or land in England and Northern Ireland. There is also the Land and Buildings Transaction Tax in Scotland, and the Land Transaction Tax in Wales.
The Aggregate Levy, a tax that applies to any commercial extraction of rock, sand and gravel.
The Capital Gains Tax, which applies to money made from sources such as selling personal possessions worth more than £6,000 (excluding cars), property and shares.
Excise Duty, which is a tariff paid on items such as alcohol and tobacco products.

It’s also worth noting that taxation systems can change over time. For example, a new tax proposed in 2021 – the Health and Social Care Levy – was later reversed by a new chancellor of the exchequer in 2022.

What are the reasons for taxation and government spending?

Taxation and government expenditure are what ensure that the public services people rely on – healthcare, education, transportation, and so on – are available, well-maintained and expanded as needed.

“Without them [taxes] it would be impossible to pay for the country’s defence services, its health, welfare and social services, its schools and universities, and its transport systems,” explains the UK Parliament website. “In addition to these huge areas of expenditure, financial support is given to other vital areas such as industry, sport, heritage and culture.”

Tax systems also enable governments to influence economic activity and initiatives. For example, the UK government offers a Research and Development Tax Relief scheme of subsidies for businesses that “work on innovative projects in science and technology.” By offering incentives and exemptions like these, governments encourage businesses to develop new technologies, advance scientific discovery, create new jobs, and drive wider economic growth.

What is the difference between a progressive and a regressive tax system?

A progressive tax system such as the UK’s income tax places a higher tax burden on higher earners. For example, in the 2023/24 financial year, there is a 20% tax threshold on UK earners’ income between £12,571 and £50,270, and a 40% tax on income between £50,271 and £125,140.

A regressive tax, on the other hand, is a tax rate that doesn’t change regardless of where – or to whom – it’s applied. These taxes tend to disproportionately affect lower-income people because a larger percentage of their income is taxed.

What is the difference between hypothecated and non-hypothecated taxes?

Taxation can also be categorised as hypothecated or non-hypothecated.

Hypothecated taxes, such as National Insurance contributions, are earmarked for specific purposes, while non-hypothecated taxes like income tax and corporation tax contribute to a wider revenue pool and offer the government more flexibility in allocation.

The public sector in the United Kingdom

The UK’s public sector is a collection of government services that require substantial funding – much of which comes from taxation.

Recent figures show that total public sector spending, when viewed as a percentage of the UK’s gross domestic product (GDP), is around 45%.

What are the key areas of public spending?

According to the government’s public spending statistics published in May 2023, the biggest areas of public expenditure in the UK include:

Social protection. Social protection is a category covering everything from housing benefit to pensions.
Health. Healthcare costs are always a significant area of public spending, and increased in the wake of the COVID-19 pandemic. The majority of health spending in the UK is overseen by the Department of Health and Social Care and helps fund the NHS.
General public services. This area has increased in recent years due to a significant increase in interest on public sector debt repayments.
Economic affairs. Recent examples of economic affairs spending include subsidising fuel and energy costs.
Education. Education spending primarily funds UK primary and secondary schools.

How are public sector budgets managed?

Public finances and decision-making in the UK must be managed prudently and transparently. Whether raising revenue through taxes or spending public funds, governments are required to outline new or amended financial plans while also seeking approval from Parliament before taking any action.

The central government is responsible for setting fiscal policy, tax policy, and allocating resources to government departments through its tax administration systems. Local authorities, meanwhile, also have budgets, and local governments manage services at the community level.

Public finance oversight in the United Kingdom

The Office for Budget Responsibility (OBR) was created to oversee and scrutinise government finance in the UK. It is responsible for:

Providing independent economic and fiscal forecasts.
Assessing the sustainability of public finances.
Evaluating the government’s performance against its fiscal targets.

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Taxation forms the lifeblood of a nation’s public sector budgets. Learn about the intricacies of taxation systems and public sector spending in this article.

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