Effective Taxation

Effective Taxation Characteristics

An effective taxation system is designed to take into account five essential characteristics or principles. Let's go over each of them in turn and try to understand them based on the personal and corporate income tax examples.

Effective Taxation: Equity Principle

Equity is broadly divided into horizontal and vertical equity. Vertical equity means that people who earn more would pay a more significant proportion of their income in tax than those who earn less, for example. Horizontal equity suggests that the effective tax rates must be the same for individuals with similar pre-tax income.But is this all there is to the equity principle? It's not all that simple! To achieve more significant equity, economists need to decide whether the tax needs to be progressive, regressive, or proportional.

Last but not least, to achieve greater equity, the tax must be challenging to avoid. For most people employed by businesses, income taxes are already deducted when they receive their paycheck, making it difficult to avoid. Freelancers, however, have to report their income themselves, which makes it more difficult for the government to monitor and achieve compliance.

Effective Taxation: Efficiency Principle

The efficiency principle is primarily based on the idea of neutrality. Neutrality means that the imposition of the tax would not alter economic agents' incentives.As businesses are responsible for withholding income taxes on behalf of their employees, income tax brackets may alter their incentives to gradually increase workers' salaries. Instead, they may wait to postpone salary increases until it becomes substantial or worthwhile.Another aspect of efficiency is that the benefits of tax collection should be outnumbered by the costs. This is primarily achieved through the cost of tax collection being as low as possible so that the remaining revenue is substantial.

Availability of information plays a prominent role in tax efficiency. On the one hand, firms directly collect the tax numbers and send the reports to the government. On the other hand, using income as a proxy for the ability to pay may not be accurate enough, as the actual ability to pay is not directly observable.

Effective Taxation: Convenience Principle

The convenience principle is based mainly on ideas of simplicity and understandability. The compliance rate will be higher if the tax is simple to understand.

Having multiple income tax brackets may improve equity. However, the convenience may decrease compared to a flat tax rate. People on fluctuating incomes may find it difficult to report their taxes. Multiple tax reliefs can lead to many filing additional forms to get tax refunds if mistakes happen.

Effective Taxation: Certainty Principle

Tax certainty primarily means that the tax will yield the revenue the government intended to collect. This means that the tax would be well-defined and will tax something feasible, like income, rather than something arbitrary, which is difficult to measure, like wealth.Additionally, the certainty principle implies that the tax system can adapt to fluctuating economic conditions. Income taxes work hand in hand with transfer payments through the mechanism of automatic stabilizers.When the economy is in a boom, income taxes will increase while transfer payments will fall, thereby stabilizing tax revenue. This also helps to regulate the level of aggregate demand in the economy. In contrast, when the economy is in a recession, income tax receipts fall, but transfer payments increase, stimulating aggregate demand.

Effective Taxation: Flexibility Principle

According to the OECD, modern taxation systems should be flexible enough to adapt to varying economic and technological changes.⁴ Technological advancements may alter the way that the competition works in various market structures.

Suppose firms get enough information about their consumers to price discriminate better based on the consumer's price elasticity of demand. In that case, they can shift their corporate income tax incidence onto consumers through higher prices.If technological advancements make capital more flexible to be employed by businesses, then the workers would be disadvantaged. How so? Suppose firms would find it easier to substitute workers for capital. In that case, they can pay the workers less and therefore pay less in payroll taxes to the government.

Effective Taxation System

An effective taxation system is a system that is founded on the five main principles: equity, efficiency, convenience, certainty, and flexibility. The difficulty in achieving these principles at once lies in the fact that there are trade-offs between them.Let's look at the possible trade-offs that may arise when designing an effective income tax system.Achieving vertical equity in income tax can be done by altering the tax brackets and the corresponding percentages of income that individuals in those brackets need to pay. Allowances and tax reliefs can aid those in the same income group with a lower ability to pay, improving horizontal equity.

Income tax is a progressive tax, which results in greater equity. However, the tax brackets can negatively impact individuals whose income fluctuates. The tax is collected, and deductions are accounted for in a given tax year.

A person who earns a lot in a particular year but less in other years may end up paying a larger proportion of their income in tax. This is compared to if the tax was collected over a larger time horizon.

If businesses react by postponing salary increases, this would also alter workers' behavior. Knowing that they won't receive their salary increase any time soon, they may get disincentivized to work to their fullest potential and shirk instead. This may also affect workers' certainty about their future income and their intertemporal consumption smoothing. They may increase their preference for higher savings now, which can discourage economic growth in the short run.Last but not least, the aim to minimize tax avoidance inevitably introduces complexity to any tax system. This means that the principle of equity is achieved through reducing adherence to the convenience principle.It can be seen that achieving all the principles of an effective taxation system at once is not an easy task due to varying and complex trade-offs. Estimating how the tax would perform in a practical setting is not an easy task either. But we are sure that after reading this article, you will probably know more about an effective taxation system design than anyone in your class. Go on, then, and share this knowledge with the world!