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 TE principles of
taxation
Principles of Taxation
Tax systems perform differing functions,
depending on the responsibilities expected of the enacting government.
In a complex, trilevel government such as that of the U.S., for example,
the benefits expected from federal, state, and local taxes vary greatly.
Lower levels of government are comparatively limited in the kinds of taxes
they are authorized to levy. Local governments traditionally depend most
heavily on property taxes, and state governments on sales and income taxes.
State and local governments are required to keep their expenditures within
the budgetary limits, determined by their own revenues augmented by payments
received from higher levels of government (such as federal grants-in-aid).
The federal government, however, can create money; it does not have to
raise enough from its tax system to balance its budget. The federal tax
system, moreover, does not function solely as a way to raise revenue but
is also the basic instrument of U.S. fiscal policy. In concert with its
control over the money supply (that is, its monetary policy), the government
aims to maintain the stability of the economy (as evidenced by price and
employment levels). In depressed periods, for example, taxes may be lowered
and budget deficits incurred so that consumers will have money to buy goods
and investors will have capital to put into industry, thus stimulating
production. In prosperous times, tax increases and budget surpluses may
be needed to hold down or prevent the inflation caused by too much money
chasing too few goods.
Among the tax systems of other nations,
wide variations exist in how money is raised and spent. Tax and expenditure
policies reveal the fundamental value system of a society. Most democracies
today derive their general notions of what constitutes a good tax system
from four principles enunciated in the 18th century by the British economist
Adam Smith.
Fairness
Of fundamental importance is that
any tax must be fair-that is, citizens should be taxed in proportion to
their abilities to pay (a concept that Smith defined somewhat ambiguously
as "in proportion to the benefit they derive from the government"). A tax
is considered fair if those who have the means to pay are assessed either
in proportion to their capacity to pay or, depending on the situation,
in proportion to what they receive from the government. Both "ability to
pay" and "benefits received," therefore, are respected criteria of equity.
Where general, widely dispersed services of government are concerned, the
two criteria are often indistinguishable, because people of greater wealth
usually have a greater stake in the well-being of the community. When government
services confer identifiable personal benefits on some individuals and
not on others, and when it is feasible to expect the users to bear a reasonable
part of the cost, financing the benefits, at least partly, by taxing the
people who benefit is considered fair. (Obviously, this method does not
apply to such services as public welfare payments.) Taxation in accordance
with appropriately applied standards of ability to pay or of benefits received
is said to meet the requirements of vertical equity (because such taxation
exacts different amounts from people in different situations). Just as
important is horizontal equity-the principle that people who are equally
able to pay and who benefit equally should be taxed equally.
Clarity and certainty
The application of a tax should be
clear and certain. This principle, considered very important by Smith,
has often been underestimated in modern tax systems (in which open and
impartial administration usually can be taken for granted). In nations
where the application of taxes is uncertain and arbitrary, however, the
public can have no confidence in the system. Even in the U.S., high rates
of inflation have sometimes created fears and uncertainties about rising
tax bills and the fairness of imposing taxes on inflated values. Such reactions
demonstrate the importance of clarity and certainty as principles of a
respected tax system.
Convenience
Compliance with a tax should be easy
and convenient. In the U.S., for example, compliance with income tax laws
increased dramatically after a system of withholding tax payments from
payrolls was introduced.
Efficiency.
A good tax system should be structured
so that it can be administered efficiently and economically. Taxes that
are costly or difficult to administer divert resources to nonproductive
uses and diminish confidence in both the levy and the government. Worse
still, waste can also be created by excessive tax rates; economic efforts
are then shunted from high- into low-yielding activities, from productive
enterprises into tax shelters, and from open, aboveboard transactions into
hidden, off-the-record participation in the underground economy. When this
happens, the important principle of tax neutrality (which maintains that
a tax should not cause people to change their economic behavior), implied
by Smith, is violated.
Smith's tax maxims have stood the test
of time remarkably well. Other basic principles have been added to the
list, but some have occasionally been proven counterproductive. An example
is the desirability of tax elasticity-that is, the automatic response of
taxes to changing economic conditions without adjustments in tax rates.
High elasticity, however, creates inequities during periods of rapid inflation
by pushing people into higher tax-rate brackets, although the value of
their incomes is failing to keep pace with rising prices. The large revenues
generated then encourage government spending just when the growing tax
burdens discourage taxpayers from working, saving, and investing. This
situation can bring about or worsen a state of economic stagnation accompanied
by inflation. In such instances, the tax levy has become too elastic, and
inflation adjustments are then necessary. See INFLATION AND DEFLATION.
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