Taxation

Taxation

Is the imposition or infliction of taxes. The process whereby charges are imposed on individuals/property by legislative branch of the state or federal government to raise funds for public purposes.

The following principles or cannons are important for good tax system when tax is imposed it must fulfil the following conditions.

Canons of Taxation (Principles)

According to Adam smith there are four important canons of taxation which are (canons of equity, certainty, convenience and economy) and other additions like canon of productivity, elasticity, flexibility, simplicity and diversity as discussed below.

1. Canon of Equity. The principle aims at providing economic and social justice to the people. According to this principle, every person should pay to the government depending upon his ability to pay. The rich class people should pay higher taxes to the government, because without the protection of the government authorities (Police, Defence, etc.) they could not have earned and enjoyed their income. Adam Smith argued that the taxes should be proportional to income, i.e., citizens should pay the taxes in proportion to the revenue which they respectively enjoy under the protection of the state.

2. Canon of Certainty. According to Adam Smith, the tax which an individual has to pay should be certain, not arbitrary. The tax payer should know in advance how much tax he has to pay, at what time he has to pay the tax, and in what form the tax is to be paid to the government. In other words, every tax should satisfy the canon of certainty. At the same time a good tax system also ensures that the government is also certain about the amount that will be collected by way of tax.

3. Canon of Convenience. The mode and timing of tax payment should be as far as possible, convenient to the tax payers. For example, land revenue is collected at time of harvest income tax is deducted at source. Convenient tax system will encourage people to pay tax and will increase tax revenue.

4. Canon of Economy. This principle states that there should be economy in tax administration. The cost of tax collection should be lower than the amount of tax collected. It may not serve any purpose, if the taxes imposed are widespread but are difficult to administer. Therefore, it would make no sense to impose certain taxes, if it is difficult to administer.

5. Additional Canons of Taxation. Activities and functions of the government have increased significantly since Adam Smith's time. Government are expected to maintain economic stability, full employment, reduce income inequality & promote growth and development. Tax system should be such that it meets the requirements of growing state activities.

Accordingly, modern economists gave following additional canons of taxation.

6. Canon of Productivity. It is also known as the canon of fiscal adequacy. According to this principle, the tax system should be able to yield enough revenue for the treasury and the government should have no need to resort to deficit financing. This is a good principle to follow in a developing economy.

7. Canon of Elasticity. According to this canon, every tax imposed by the government should be elastic in nature. In other words, the income from tax should be capable of increasing or decreasing according to the requirement of the country. For example, if the government needs more income at time of crisis, the tax should be capable of yielding more income through increase in its rate.

8. Canon of Flexibility. It should be easily possible for the authorities to revise the tax structure both with respect to its coverage and rates, to suit the changing requirements of the economy. With changing time and conditions the tax system needs to be changed without much difficulty. The tax system must be flexible and not rigid.

9. Canon of Simplicity. The tax system should not be complicated. That makes it difficult to understand and administer and results in problems of interpretation and disputes. In India, the efforts of the government in recent years have been to make the system simple.

10. Canon of Diversity. This principle states that the government should collect taxes from different sources rather than concentrating on a single source of tax. It is not advisable for the government to depend upon a single source of tax, it may result in inequity to the certain section of the society; uncertainty for the government to raise funds. If the tax revenue comes from diversified source, then any reduction in tax revenue on account of any one cause is bound to be small.

Systems of Taxation

There are mainly three tax systems.

1. Progressive tax systems. This is a tax system in which the tax rate increase with increase in income. It is aimed at reducing the gap between the rich and the poor (income gap) or income inequality.

   Example of progressive tax is direct tax from income which is PAYE (Pay As You Earn).

   It can be illustrated as follows.

   

2. Proportional tax system. This is a tax system in which the tax rate is constant or fixed regardless of the changes in income. Aim to collect more money. Proportional taxes maintain equal tax incidence regardless of the ability-to-pay and do not shift the incidence disproportionately to those with a higher or low economic well-being

   Graphical illustration.

   

3. Regressive tax system. A tax system where the tax rate decreases with increase in income (The higher the income, the low the proportional of the income is paid as tax and the low the income, the higher the proportional of the income is paid as tax. It is mainly used to encourage investments. Example Social security tax, for 2007 in USA, you pay 6.2% tax on wages up to a maximum wage of $97,500. Therefore:

   • A person who makes $30,000 a year pays$1,860 (30,000 x 0.062) in tax or 6.2% of wages
   • A person who makes $200,000 a year pays$6,045 (97,500 x 0.062) in tax or 3% of wages
   • A person who makes $500,000 a year pays$6,045 (97,500 x 0.062) in tax or 1.2% of wages

   Since the richest people pay the smallest percentage of their in tax, it is a regressive tax.

Requirements of a Good Tax Structure/System

A good tax system is crucial for the effective functioning of a country's economy. The government should structure its tax system to meet the following principles to ensure it is fair, efficient, and beneficial to the economy:

1. Revenue Generation for Public Services
   The primary goal of taxation should be to raise funds for public services, such as infrastructure, health, and education.

2. Ability to Pay Principle
   Taxes should be levied according to an individual's or corporation's ability to pay, primarily based on income and property.

3. Non-Discriminatory
   Tax policies should be fair, ensuring no discrimination between individuals or groups based on income, social status, or location.

4. Flexibility and Simplicity
   The tax system should be flexible to adjust to changing economic conditions, and simple so that taxpayers can easily understand it.

5. Comprehensiveness
   A good tax system should be comprehensive, covering a wide range of economic activities and ensuring that all sectors contribute.

6. Economical
   The cost of administering the tax system should be low. This means reducing the cost of tax collection and minimizing bureaucratic inefficiencies.

7. Avoid Double Taxation
   The tax system should avoid double taxation, where an individual or business is taxed twice on the same income or transaction.

Types of Taxes

a. Direct Taxes

Direct taxes are taxes that are imposed directly on individuals or organizations. The burden of these taxes cannot be shifted to others.

Examples of Direct Taxes:

• Pay As You Earn (PAYE): Income tax deducted from an employee's salary.
• Corporation Tax: Tax levied on company profits.
• Capital Gains Tax: Tax on profits from the sale of assets.
• Agricultural Revenue Tax: Tax on income from agricultural activities.
• Estate Duty: Tax on estates or inheritances after death.
• Property Tax: Tax on the ownership of property.
• Inheritance Duty: Tax on assets inherited from a deceased person.
• Surtax: Additional tax imposed on high-income individuals.

Advantages of Direct Taxes

1. Economical: The cost of collecting direct taxes is minimal.
2. Progressive: Direct taxes are generally progressive, meaning the higher the income, the higher the tax, reducing income inequality.
3. Predictability: Taxpayers know the amount of tax to be paid in advance.
4. Simple: Direct taxes are relatively easy to understand.
5. Inflation Control: Can help reduce inflation by limiting purchasing power.
6. Tax Incidence: The burden of direct taxes is easy to determine.

Disadvantages of Direct Taxes

1. Discourages Savings: Higher income taxes may discourage saving.
2. Disincentive to Work: High direct taxes might discourage individuals from working harder.
3. Evasion: There is the potential for tax evasion or avoidance.
4. Discourages Consumption: Higher taxes reduce disposable income, affecting consumption levels.
5. Investment Impact: Tax on profits can discourage business investments.
6. Not Universal: The unemployed may not contribute directly to taxes.

b. Indirect Taxes

Indirect taxes are levied on commodities and can be passed on from one person to another, usually in the form of higher prices.

Examples of Indirect Taxes:

1. Excise Duty: Tax on locally produced goods.
2. Sales Tax: Tax imposed on the sale of goods and services.
3. Customs Duty: Taxes on imported and exported goods.
4. Value Added Tax (VAT): Tax on the value added at each stage of production.

Advantages of Indirect Taxes

1. Hard to Evade: Harder for individuals to evade compared to direct taxes.
2. Revenue Generation: Often results in higher revenue.
3. Convenient: Taxpayers find it easy to pay through the purchase of goods.
4. Consumer Awareness: The tax is felt by consumers through higher prices.
5. Regulatory Function: Can be used to control the consumption of harmful goods (e.g., alcohol, cigarettes).
6. Protects Domestic Industry: Helps protect local industries from foreign competition.
7. Encourages Hard Work: Higher prices may motivate people to work harder to maintain purchasing power.

Disadvantages of Indirect Taxes

1. Regressive: They tend to affect the poor more since everyone pays the same rate, regardless of income.
2. Cost Push Inflation: Can lead to higher costs for producers, which may be passed on to consumers in the form of higher prices.
3. Encourages Black Market: High indirect taxes can lead to increased smuggling and black-market activities.
4. Uncertain Tax Incidence: It's not always clear who bears the burden of the tax.
5. Discourages Industrialization: High taxes on goods may discourage local production due to higher costs.
6. Inefficient Resource Allocation: Taxes may distort business decisions, leading to misallocation of resources.

Why Do Most LDCs Depend More on Indirect Taxes than Direct Taxes?

Most Less Developed Countries (LDCs) rely more on indirect taxes due to several reasons:

1. Ease of Collection: Indirect taxes are easier to collect since they are included in the price of goods and services, making it difficult for individuals to evade.
2. Wider Tax Base: Indirect taxes capture a broader segment of the population, including those who may not earn taxable income but still consume goods and services.
3. Administrative Simplicity: LDCs may lack the infrastructure to effectively assess and collect direct taxes from individuals and businesses, whereas indirect taxes are easier to administer.
4. Higher Revenue Potential: Indirect taxes can generate significant revenue, especially in countries where consumption of goods is widespread.

Value Added Tax (VAT)

VAT is a consumption tax imposed on the value added to goods and services at each stage of production.

Advantages of VAT

1. Widens the Tax Base: Reaches a large number of consumers.
2. Easy to Calculate: Simplified when proper records are kept.
3. Fair and Non-Discriminatory: Taxation is uniform across all goods and services.
4. Encourages Record Keeping: Traders are incentivized to keep accurate records of transactions.
5. Consumer-Based: Shifts the tax burden to consumers, making it easier to identify who is paying the tax.
6. Pre-Government Use: Taxpayers collect VAT before remitting it to the government.

Disadvantages of VAT

1. Regressive: Affects lower-income consumers more than wealthier ones.
2. Price Increase: Leads to higher prices for consumers, affecting purchasing power.
3. Not Economical: Collecting VAT can be administratively costly.
4. Complexity: Not always easy for consumers to understand the tax system.
5. Delays Revenue: VAT payments are remitted later, which can delay government cash flow.

Important Terms in Taxation

1. Tax Evasion. Is a situation where tax payer refuses to pay the tax assessed to her/him by tax officers. It is illegal.

2. Tax Avoidance. Is a situation where a tax payer falls to pay tax using the loophole in the tax law. It is not illegal.

3. Specific Tax. This is a tax of a fixed amount per unit purchased.

4. Ad Valorem Tax. This refers to a tax which is based on the value of the goods it is percentage tax for example, sales tax, property tax etc.

5. The Burden of a Tax. Refers to the feeling of tax payer as he/she pays the tax.

6. Tax Benefit Principle. It state that 'the amount of tax paid by tax payer should be related directly to the benefit the tax pay will get after the government has spent its revenue.

7. Ability to Pay Principle. It state that, 'the tax imposed on tax payers should be according to their taxable capacity i.e. high income earners higher taxes and lower income earns lower taxes.

Incidence of Taxation

Refers to the burden to pay tax, the final payer of the tax i.e. when a tax is paid who actually pays the tax.

The incidence of tax can either be formal incidence (among burden) or effective incidence (final resulting of the tax)

The incidence of tax can be seen in the following cases case of direct.

1. Case of direct tax. In case of direct tax the incidence rest on the person who pays the tax first. It can be shifted to someone else.

2. Case of indirect tax. In indirect tax the incidence can be shifted into two ways

There are

1. Forward shift: is a situation where the tax burden is shifted to final consumer inform of high prices.
2. Backward shift: as tax is imposed the seller, negotiate with the producer to lower the price.

The incidence of a tax under indirect tax can be shifted either to the supplier or buyer (consumer). This shifting will depend on elasticity of demand for the commodities concerned, this can be good shown as follows:

When the demand is elastic. Elastic demand refers to the elasticity where a small change in price (increase or decrease) leads to big change in quantity (increase or decrease.)

When commodities have elastic demand the burden of tax is born by the seller and cannot be shifted to the buyer. An increase in tax means an increase in price leading to a big increase in quantity demanded.

Illustration:

When the demand is perfectly inelastic. Perfectly inelastic demand refers to the elasticity in which price changes do not change the quantity demanded. This is the demand of necessary goods which do not have substitute. In case of such goods an introduction of tax would lead to an increase in price and the burden of the tax is shifted to the buyer.

When the demand is perfectly elastic. Perfectly elastic refers to elasticity in which the price remains constant with changes in quantity. The whole burden of the tax is paid by the supplier.

When the demand is inelastic. The elasticity of demand of commodity is said to be inelastic when a big change in price leads to a small change in quantity demand. In this case the burden of tax falls to the buyer (consumer).

There are factors that may determine the shifting of the incidence.

1. The market power of the buyers and sellers. For a case of monopoly the whole burden is shifted to the buyer through price discrimination while under perfect competition it taken by supplier.

2. The tax base. If the tax base is narrow its difficult to shift the tax burden i.e. if few commodities are taxed and a tax is introduced on other commodities the tax payer would substitute those tax commodities with untaxed commodities and vice versa.

Why Pay Taxes? (Positive Effects of Taxation)

Taxes play an essential role in the functioning of a country's economy, and they bring various positive effects:

1. To Increase Government Revenue
   Taxes are the primary source of revenue for the government, enabling it to fund essential public services and infrastructure projects.

2. To Control Harmful Goods
   Taxes can be used to reduce the consumption of harmful goods such as cigarettes, alcohol, and sugary products. By imposing excise duties or sales taxes on these goods, governments can discourage their consumption.

3. To Reduce the Gap Between the Rich and the Poor
   A progressive tax system ensures that higher-income individuals pay a larger share of taxes, helping reduce income inequality and promoting a more equitable distribution of wealth.

4. To Enable the Government to Provide Public Services
   Taxes fund essential services like healthcare, education, transportation, and security, which improve the quality of life for citizens and promote social welfare.

5. To Control Importation of Goods and Correct the Balance of Payments
   Taxes on imports (e.g., customs duties) help reduce the inflow of foreign goods, protecting domestic industries and correcting imbalances in the country's trade.

6. To Protect Domestic and Infant Industries
   By imposing taxes or tariffs on foreign goods, the government can protect emerging or local industries from international competition, helping them grow and develop.

7. To Control Allocation of Resources
   Taxation can influence the allocation of resources in the economy, guiding resources toward sectors that the government deems essential (e.g., healthcare, education, green energy) through tax incentives or exemptions.

8. To Stabilize the Economy
   Taxes can help manage the business cycle. For instance, increasing taxes during periods of inflation can help cool down the economy, while reducing taxes during a recession can stimulate spending and investment.

Negative Effects of Taxation

While taxes have many benefits, there are also negative effects that need to be managed carefully:

1. It Discourages Savings
   Higher taxes, especially on income or profits, can reduce disposable income, leaving individuals and businesses with less money to save.

2. It Discourages Hard Work
   High taxes on earnings may reduce the incentive to work harder or longer hours, as individuals may feel that a significant portion of their earnings will be taxed away.

3. It Discourages Investment
   Taxes on profits or capital gains can deter individuals and businesses from making investments, as the returns on investment may be taxed at high rates.

4. It Can Lead to Illegal Activities
   High tax rates may drive individuals and businesses to engage in tax evasion or other illegal activities to reduce their tax burden, such as underreporting income or engaging in the black market.

5. It May Cause Inflation
   Certain types of taxes, such as sales taxes or excise duties, can lead to higher prices for goods and services, contributing to demand-pull inflation or cost-push inflation.

6. It May Cause Political and Social Instability
   If the government fails to manage tax revenue effectively or uses it inefficiently, citizens may become disillusioned, leading to political instability or social unrest.

Taxable Capacity

Taxable capacity refers to a country's ability to collect sufficient tax revenue without adversely affecting economic activity. It is the maximum amount of tax that can be imposed on the population while still maintaining a healthy and productive economy.

Factors Affecting Taxable Capacity

1. Real Wealth of the Country (Resources)
   A country's wealth, in terms of natural resources, infrastructure, and human capital, affects its ability to generate revenue through taxes. Countries rich in resources (e.g., oil, minerals) may have a higher taxable capacity.

2. Size of Population
   The larger the population, the higher the potential for taxation. However, this also depends on the proportion of the population actively participating in the economy.

3. Level of Economic Development
   Developed economies with a large industrial base and higher income levels are generally able to support a higher taxable capacity compared to developing countries.

4. Possibility of Tax Evasion and Corruption
   If tax evasion is widespread, or corruption is prevalent, it reduces the government's ability to collect taxes and increases the informal sector, which is often not taxed.

5. Level of Income
   The lower the income levels of the population, the lower the taxable capacity, as there is less wealth to tax. In contrast, higher incomes can support higher tax rates.

6. Attitude of Taxpayers Towards Taxes
   If taxpayers are not willing to pay taxes or perceive the tax system as unfair, it can lower the country's taxable capacity. Public trust in the government is crucial for effective tax collection.

7. Income Distribution
   A country with extreme income inequality may have a lower taxable capacity, as the wealthier segments may evade taxes, and the poorer segments may not have enough income to tax.

8. Level of Inflation
   High inflation can reduce the real value of taxes and distort the taxable capacity of an economy, making it more difficult for individuals to pay taxes on their income.

Qn. Discuss why the taxable capacity is low in less developed country.

Qn. Discuss the measure of the country can adopt to widen tax base and increase taxable capacity.