Principles Of Taxation
The 18th-century economist and philosopher Adam Smith attempted to systematize the rules that should govern a rational system of taxation. In The Wealth of Nations he set down four general canons:
I. The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.…
II. The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and to every other person.…
III. Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.…
IV. Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state.…
(1) the belief that taxes should be based on the individual’s ability to pay, known as the ability-to-pay principle, and (2) the benefit principle, the idea that there should be some equivalence between what the individual pays and the benefits he subsequently receives from governmental activities. The fourth of Smith’s canons can be interpreted to underlie the emphasis many economists place on a tax system that does not interfere with market decision making, as well as the more obvious need to avoid complexity and corruption.
Distribution of tax burdens
Various principles, political pressures, and goals can direct a government’s tax policy. What follows is a discussion of some of the leading principles that can shape decisions about taxation.
Horizontal equity
The principle of horizontal equity assumes that persons in the same or similar positions will be subject to the same tax liability. In practice this equality principle is often disregarded, both intentionally and unintentionally. Intentional violations are usually motivated more by politics than by sound economic policy. Debate over tax reform has often centred on whether deviations from “equal treatment of equals” are justified.
The ability-to-pay principle
The ability-to-pay principle requires that the total tax burden will be distributed among individuals according to their capacity to bear it, taking into account all of the relevant personal characteristics. The most suitable taxes from this standpoint are personal levies (income, net worth, consumption, and inheritance taxes). Historically there was common agreement that income is the best indicator of ability to pay. The early dissenters believed that equity should be measured by what is spent rather than by what is earned modern advocates of consumption-based taxation emphasize the neutrality of consumption-based taxes toward saving , the simplicity of consumption-based taxes, and the superiority of consumption as a measure of an individual’s ability to pay over a lifetime. Some theorists believe that wealth provides a good measure of ability to pay because assets imply some degree of satisfaction (power) and tax capacity, even if (as in the case of an art collection) they generate no tangible income.
The ability-to-pay principle also is commonly interpreted as requiring that direct personal taxes have a progressive rate structure, although there is no way of demonstrating that any particular degree of progressivity is the right one. Because a considerable part of the population does not pay certain direct taxes—such as income or inheritance taxes—some tax theorists believe that a satisfactory redistribution can only be achieved when such taxes are supplemented by direct income transfers or negative income taxes .
The benefit principle
Under the benefit principle, taxes are seen as serving a function similar to that of prices in private transactions; that is, they help determine what activities the government will undertake and who will pay for them. If this principle could be implemented, the allocation of resources through the public sector would respond directly to consumer wishes.
It is difficult to implement the benefit principle for most public services because citizens generally have no inclination to pay for a publicly provided service—such as a police department—unless they can be excluded from the benefits of the service. The benefit principle is utilized most successfully in the financing of roads and highways through levies on motor fuels and road-user fees (tolls). Payroll taxes used to finance social security may also reflect a link between benefits and “contributions,” but this link is commonly weak, because contributions do not go into accounts held for individual contributors.
Economic efficiency
The requirement that a tax system be efficient arises from the nature of a market economy. Although there are many examples to the contrary, economists generally believe that markets do a fairly good job in making economic decisions about such choices as consumption, production, and financing. Thus, they feel that tax policy should generally refrain from interfering with the market’s allocation of economic resources. That is, taxation should entail a minimum of interference with individual decisions. It should not discriminate in favour of, or against, particular consumption expenditures, particular means of production, particular forms of organization, or particular industries. This does not mean, of course, that major social and economic goals may not take precedence over these considerations. It may be desirable, for example, to impose taxes on pollution as a means of protecting the environment.
Ease of administration and compliance
In discussing the general principles of taxation, one must not lose sight of the fact that taxes must be administered by an accountable authority. There are four general requirements for the efficient administration of tax laws: clarity, stability (or continuity), cost-effectiveness, and convenience. Administrative considerations are especially important in developing countries, where illiteracy, lack of commercial markets, absence of books of account, and inadequate administrative resources may hinder both compliance and administration. Under such circumstances the achievement of rough justice may be preferable to infeasible fine-tuning in the name of equity.
Clarity
Tax laws and regulations must be comprehensible to the taxpayer; they must be as simple as possible (given other goals of tax policy) as well as unambiguous and certain—both to the taxpayer and to the tax administrator. While the principle of certainty is better adhered to today than in the time of Adam Smith, and arbitrary administration of taxes has been reduced, every country has tax laws that are far from being generally understood by the public. This not only results in a considerable amount of error but also undermines honesty and respect for the law and tends to discriminate against the ignorant and the poor, who cannot take advantage of the various legal tax-saving opportunities that are available to the educated and the affluent. At times, attempts to achieve equity have created complexity, defeating reform purposes.
Stability
Tax laws should be changed seldom, and, when changes are made, they should be carried out in the context of a general and systematic tax reform, with adequate provisions for fair and orderly transition. Frequent changes to tax laws can result in reduced compliance or in behaviour that attempts to compensate for probable future changes in the tax code—such as stockpiling liquor in advance of an increased tariff on alcoholic beverages.
Cost-effectiveness
The costs of assessing, collecting, and controlling taxes should be kept to the lowest level consistent with other goals of taxation. This principle is of secondary importance in developed countries, but not in developing countries and countries in transition from socialism, where resources needed for compliance and administration are scarce. Clearly, equity and economic rationality should not be sacrificed for the sake of cost considerations. The costs to be minimized include not only government expenses but also those of the taxpayer and of private fiscal agents such as employers who collect taxes for the government through the withholding procedure.
Convenience
Payment of taxes should cause taxpayers as little inconvenience as possible, subject to the limitations of higher-ranking tax principles. Governments often allow the payment of large tax liabilities in installments and set generous time limits for completing returns.
