Tax policy

Tax policy is the choice by a government as to what taxes to impose, in what amounts, and on whom. It has both microeconomic and macroeconomic aspects. The macroeconomic aspects concern the overall quantity of taxes to collect, which can inversely affect the level of economic activity; this is one component of fiscal policy. The microeconomic aspects concern issues of fairness (whom to tax) and allocative efficiency (i.e., which taxes will have how much of a distorting effect on the amounts of various types of economic activity).A country’s tax regime is a key policy instrument that may negatively or positively influence the country's economy.

Tax policies have significant economic consequences for both a national economy and particular groups within the economy (e.g., households, firms and banks). Tax policies are often designed with the intention of stimulating economic growth—although economists differ significantly about which policies are most effective at fostering growth.

Taxation is as much a political issue as an economic issue. Political leaders have used tax policy to promote their agendas by initiating various tax reforms: decreasing (or increasing) tax rates, changing the definition of taxable income, creating new taxes on specific products, and so forth. Of course, no one particularly wants to pay taxes. Specific groups, such as small business owners, farmers, or retired individuals, exert significant political effort to reduce their share of the tax burden. Tax codes are packed with rules that benefit a certain group of taxpayers while inevitably shifting more of the burden to others.

Main reasons for taxation

There are some main reasons why government needs to levy taxes:

1. Market failure - mainly to discourage purchases of that product (any tax creates a disincentive, so consumers will reduce their purchases and seek alternatives).
   • Taxes can create incentives promoting desirable behaviour and disincentives for unwanted behaviour. Tax changes human behaviour and thus influences the market outcome. For example, in presence of externalities, we want to change the market outcome to reach the social optimum (otherwise there is a deadweight loss of externality) - in these cases policymakers implement excise taxes, carbon tax etc.
2. To generate revenue.
   • Taxation is the most important source of government revenue. Governments can use tax revenue to provide public services such as social security, health care, national defence, and education.
3. Changing the distribution of income and wealth.
   • Taxation provides a means to redistribute economic resources toward those with low income or special needs (tax revenue can be used for transfer payments such as welfare benefits).

The principles of sound tax policy

The principles of sound tax policy are simplicity, transparency, neutrality, and stability. These principles should serve as touchstones for policymakers and taxpayers in the whole world.

1. Simplicity
   • Tax codes should be easy for taxpayers to comply with and for governments to administer and enforce. The main reason for it is that the complexity of tax code can create real costs for taxpayers in the form of compliance burdens.
2. Transparency
   • What taxpayers must pay and when they must pay it should be clearly defined by tax policies. Hiding tax burdens in complex structures should be avoided and any changes to the tax code should be made with careful consideration, input, and open hearings.
3. Neutrality
   • Taxes should neither encourage nor discourage personal or business decisions. The main purpose of taxes is to raise needed revenue, not to favor or punish specific industries, products or activities.
4. Stability
   • There should be consistency and predictability in the tax code. Enacting temporary tax laws, including tax holidays, amnesties, and retroactive changes should be avoided by governments.
5. Equity and fairness
   • Similar situated taxpayers should be taxed similarly. This includes vertical and horizontal equity.
6. Certainty
   • Tax rules should be clearly specified, knowing when a tax should be paid and how was determined. This certainty gives people the confidence that the tax has been calculated correctly.
7. Minimum tax gap
   • Having well structured tax laws is essential to minimize non-compliance. Appropriate enforcement efforts are crucial to prevent non-compliance, insufficient efforts result in inequities and revenue losses.
8. Economic growth and efficiency
   • The tax policies should not reduce economic growth and efficiency. The goal is to maximize this by creating a tax system that is aligned with economic principles and the goals of the jurisdiction that has imposed the tax.

Philosophy

Policymakers debate the nature of the tax structure they plan to implement (i.e., how progressive or regressive) and how they might affect individuals and businesses (i.e., tax incidence).

The reason for such focus is economic efficiency as advisor to the Stuart King of England Richard Petty had noted that the government does not want to kill the goose that lays the golden egg. Paradigmatic efficient taxes are those that are either nondistortionary or lump sum. However, economists define distortion only according to the substitution effect, because anything that does not change relative prices is nondistortionary. One must also consider the income effect, which for tax policy purposes often needs to be assumed to cancel out in the aggregate. The efficiency loss is depicted on the demand curve and supply curve diagrams as the area inside Harberger's Triangle.

National Insurance in the United Kingdom and Social Security in the United States are forms of social welfare funded outside their national income tax systems, paid for through worker contributions, something labeled a stealth tax by critics.

Administration

The implementation of tax policy has always been a tricky business. For example, in pre-revolutionary colonial America, the argument "No taxation without representation" resulted from the tax policy of the British Crown, which taxed the settlers but offered no say in their government. A more recent American example is President George H. W. Bush's famous tax policy quote, "Read my lips: no new taxes."

Efficient tax administration encourage businesses to become formally registered, expanding the tax base and increasing revenues. An unfair tax administration can harm the tax system and reduce the government legitimacy. In many developing countries, the non-success of improving the tax administration while introducing new tax systems has led to the widespread of tax evasion and lower tax revenues. Furthermore,is important to keep rules clear and simple to encourage compliance. High tax evasion is associated with complicated tax systems. Having a well designed and simple tax system is able to increase employment, investment and transparency. Tax administration ecosystem is also changing, with the introduction of new analytical tools and technology, because of this digital information flows are increasing. Consequently, administration is operating in a way in which they increase incentives for compliant taxpayers.

Administrative costs

Modern taxation systems have the capacity to impose a heavy burden on taxpayers, and particularly on small business taxpayers. That burden typically consists of three elements. Firstly, there are the taxes themselves. Secondly, there are the efficiency costs (variously referred to as deadweight losses or excess burden). And finally, there are the administrative costs (sometimes referred to as operating costs) of the tax system.

When implementing some new parts of tax policy or reorganizing it, policymakers always have to consider the weight of administrative costs of taxation. There are two main types of administrative costs:

1. Direct administrative costs
2. Indirect administrative costs

Direct administrative costs

Direct administrative costs are on the government side (the burden is borne by the government). Allers (1994, p. 19) defines administrative costs as “costs incurred by (mainly) public sector agents in order to administer the tax-benefit system”. He then goes on to note that “it is not immediately obvious, exactly, which activities should be attributed to the operation of the … system” (p. 19). Administrative costs are mainly connected to running the tax collection office - it includes salaries of staff, costs of legislative enactment relating to the tax system, judicial costs of administration of the tax dispute system and many more.

Indirect administrative costs

Indirect administrative costs are on the side of taxpayers (the burden is borne by the government). Tax compliance costs are those costs “incurred by taxpayers, or third parties such as businesses, in meeting the requirements laid upon them in complying with a given structure and level of tax” (Sandford, Godwin and Hardwick, 1989, p. 10). Indirect administrative costs are mainly connected to the costs of complying with tax requirements - it includes the costs of labour/time consumed in completion of tax activities, filling out forms, record keeping, the fees paid to professional tax advisers, transfer pricing and many more.

Equity vs. Efficiency

An equity-efficiency tradeoff appears when there is some kind of conflict between maximizing the equity and maximizing economic efficiency. The trade-off between equity and efficiency is at the heart of many discussions of tax policy. Two questions are debated. First, there is disagreement about the nature of the trade-off . To reduce inequality, how much efficiency do we have to give up? Second, there is a disagreement about the relative value to be attributed to the reduction in inequality compared to the reduction in efficiency.

Some people claim that inequality is the central problem of society, and society should simply minimize the extent of inequality, regardless of the consequences to efficiency. Others claim that efficiency is the central issue. These disagreements relate to social choices between equity and efficiency.

Equity

Equity can be divided into two main groups: horizontal equity and vertical equity.

1. Vertical equity
   • Vertical equity is a method of taxation based on the principle that the higher the income of an individual is the higher is the personal income tax liability (i.e. as your income goes up, you pay more). Vertical equity is often more achievable than horizontal equity, because horizontal equity is harder to implement - it is not easy to define and it can be undermined by loopholes and deductions.Since this method take into consideration the ability to pay of taxpayers, nowadays it is one of the most accepted taxation methods by various countries around the world.
   • The ability to pay principle, says that the amount of a tax a person pays has to be dependent on the burden the tax will create with regard to the wealth of an individual.Vertical equity operates on the principal of people with higher incomes paying more taxes, through progressive tax rates. In progressive taxation, the amount of taxes paid increases with income.In this tax system people are divided in tax brackets, each tax bracket has a different tax rate, with high income brackets paying more taxes. With this taxation system, the effective tax rates increase with income.Furthermore, another possibility is the proportional tax method in which the income is charged at a single rate regardless of income.This taxation method is also known as flat taxes.
2. Horizontal equity
   • The basic principle of horizontal equity is based on the concept of distributive justice,in which taxpayers should pay the same level of income tax in proportion to their respective income groups. Most important,but more costly is to define income groups, knowing that each individual consumes and saves in different ways, making it very hard for tax policymakers.Horizontal equity requires a tax system that it does not give preference to certain individuals or companies. It makes sure that we don´t have discrimination on the grounds.Horizontal equity is a constant topic of tax policy discussions and in many countries it is a cause of several exemptions, deductions and special provisions.

Efficiency

Efficiency for economists is equal to the concept of Pareto efficiency. Pareto efficiency means the situation of resource allocation where the concept of 'net' is dominant. In other word, basically we need to make someone worse in order to make others better under this efficiency. To seek for the efficiency, it is necessary to build the decentralized market mechanism. And to build that mechanism, tax system is often seen as an obstacle. Here, we need to think about the balance between efficiency and equity. And the best point of this balance is called 'Pareto improvement'. This is the ideal answer to reply for the question of which policies should be implemented.

Social Choice

The choices or decision of government are one of social choices. And social choice consists of two elements. First, it is the individual level. Second, it is the society's level. As far as the individual level, each individual builds their preference and has their utility following the budget's constraint and so on. This can make the indifference curve. And we can say that the points which are on this curve are matched to pareto efficiency. In the society's level, the curve are created by seeing the participants as group A and group B. Here, the curve becomes the inverse proportional one which is very common style in the Pareto efficiency's curve. In this curve, when group A's utility will get down, group B's utility will get increased. The relation between them is like trade-off style. This is the very typical example of social indifference curve (There are other curves in other ways: Utilitarian way and Rawlsian way. And I will introduce them in the below paragraph). In the above, I mentioned about the thinking way or the process of social choice. Now, when we try to take some policies, we need to measure the net benefits of different groups and to think about if the project is the Pareto improvement. If the project has the net positive gains and reduces measured inequality, it should be taken. If it is not so clear to understand so, we need to have other points to judge. Basically, there are three ways to do so: the compensation principle, the trade-off across measures of efficiency and equality, and the weighted benefits approach. The latter two are relatively easy to understand. The trade-off one is the judgement based on the contemplation of efficiency and equality. The weighted benefits approach is focused on the total amount of utility. When we think about the compensation principle, we need to care about the willingness to pay the tax. If people are motivated to pay, the consumer surplus is getting higher. And in this principle, when the willingness to pay is more than the cost to do so (even when the cost is higher for some people), the projects should be taken. The compensation principle can overcome the difficulty of taxation due to the intervening efficiency.

Utilitarian curve

In the above paragraph, I mentioned that social indifference curve becomes the inverse proportional curve. But if you take the position of utilitarianism, the shape of curve will be different. The curve becomes straight line. It means that two different groups' utility can make trade-off completely. Here, the differentiation of individuals or each group becomes meaningless. So the society does not need to care about how to take the balance between them. The welfare of society is literally equal to the total amount of welfare of group A and group B.

Rawlsian curve

Social indifference curve from the view of Rawlsian approach becomes L shape. This is related to the Rawls's approach to social justice. In his approach, the state needs to secure some basic human rights and some economic basements from the deprivation. And when we think about its economic aspects, Rawls shows that the state gives the minimum utility to the people. Here, in this approach, the welfare of society is equal to the welfare of worst-off individual. There is no trade-off relation here because the certain utility is not changeable. Therefore, the curve in this approach becomes L shapes.

See also

• Tax incidence
• Tax law
• Tax policy
• Mirrlees, James; Adam, Stuart; Besley, Tim; et al. (2011). Tax by design. Oxford University Press. ISBN 978-0-19-955374-7.