Tax Expenditure Management - Literature review Example

of the current system The Current comprehensive income tax treatment system for household savings entails the taxation of both incomes from savings earnings and incomes from labour (Mirrlees, 2008:287). In this respect, the households are discouraged from saving, considering that the households are not sure of the consequences of their savings, in relation to whether their savings will have similar values in the future as they do currently, or their savings will have lost value in the future. The two concepts associated with the relationship between the present value of an investment and the future value is the concept of inflation (Furman, 2008:n.p.). Inflation is the process by which an equal amount of money will purchase few commodities in the future, than the money would purchase presently (Kim, 2008:22). Therefore, the current system of taxation of the households incorporates both taxation of the savings that the households make presently and the taxation of the earnings that such incomes will be earning subsequently in the course of the savings life-cycle (Mirrlees, 2008:294). The consequence of this is that; there is a distortion in the timing of consumption, where the customers would like to save some of their incomes to consume it in the future after it has gained some more returns, but they are not sure on whether inflation fluctuation will lower the value of their investments in the future (Mirrlees, 2008:284). Therefore, the current comprehensive income tax treatment system of savings is associated with the reduction of the after-tax returns, compared to the pre-tax returns. Thus, the large fraction of the population lives under conditions of uncertainties regarding whether to consume their incomes presently or to save the incomes for the future (Mirrlees, 2008:284). The second issue that is associated with the current comprehensive income tax treatment of savings is that; it creates inequality in relation to the type of assets that households should saving in, considering that the current system does not provide for uniform taxation system for all types of investment assets (Mirrlees, 2008:294). The taxation of financial assets, pensions and housing, which represent different types of investment assets are done differently under the current comprehensive income tax treatment system of households’ savings, thus placing some category of population at an advantage over the others (Valle, 2001:56). This is because, since some assets are taxed throughout the course of the savings life-cycle, while others are only taxed at the end of the life-cycle during the withdrawal and expending (Stern, 1987:62). This inequality aspect of the current taxation system is a major concern for a large fraction of the taxpayers’ population. In conclusion therefore, the current standard income taxation of savings makes it hard to design a system of neutral tax, considering that the taxation of capital gains on the basis of accrual, as opposed to the basis of disposal means that the plan to defer taxation of the asset to a later date is not accomplished (Mirrlees, 2008:296). Considering that the essence of saving for a tax payer is to delay taxation for the period of time that saving is done, the application of the current standard income tax treatment of savings, which is part of the whole comprehensive income taxation system, erodes such gains for the tax payers. In essence then, the taxation of returns serves to create a distortion to the saving patterns, both from the time and the asset type perspectives (Mirrlees, 2008:296). In this respect, the current comprehensive income tax becomes prohibitive to savings, and thus the need for a fair and well balanced system that will eliminate the distortions. Description of the proposed recommendations The recommendations to address the limitations associated with the current comprehensive income taxation of savings, is to establish a savings-neutral system, which ensures that the taxation of savings is deferred for the period that the savings are made, to create more value for the household savings (Mirrlees, 2008:297). The recommendations seek to eliminate the distortions in terms of time and type of asset that is associated with the current system of taxation, and thus leave the households free to make a choice regarding making consumption today or in the future without any uncertainties (Gruber, 2003:52). In this respect, the recommendations proposed are in form of three taxation approaches to achieving the savings-neutral system. These methods include: Labour earnings tax approach This is a proposed neutral-savings taxation system for the household savings, which entails the collection of taxes upfront, and then leaving the rest of the earnings derived from savings free from taxation (Mirrlees, 2008:285). Under this proposed savings-neutral system, the households will only be charged taxes the first time they make savings on different assets or investments, and then the subsequent returns that the savings will earn will not be subject to tax, until the household withdraws the savings (Helminen, 1999:33). Cash-flow expenditure tax approach This is another proposed taxation system that enhances the neutral principle of taxation, where all the incomes that is saved is not subjected to any taxation, until the time that the income is withdrawn (Mirrlees, 2008:285). Therefore, this taxation system entails the subjection of savings to tax, only at the point where they are being spent. This system of taxation is similar to putting the savings in a tax- deferred account where they will start earning returns until they are withdrawn and spent, and then taxation is done at this point, which is the same case with the pension savings schemes (Mirrlees, 2008:297). Income tax with a rate-of-return allowance The third proposed savings-neutral taxation system is the income tax with a rate-of-return allowance, which is a taxation system that entails the taxation of the excess earnings from savings and investments made by the individuals that may earn supernormal profits, while leaving the normal earnings free from taxation (Mirrlees, 2008:285). The earnings from labour by the households are also subjected to taxation under this system, where both the supernormal returns and the labour earnings are all charged at the same rate. This method is beneficial, since it provides the government with upfront taxes, while also offering less disruptive methodology of introducing a savings-neutral system of taxation (Mirrlees, 2008:299). Purpose for providing a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers A high rate of inflation in the future serves to reduce the present value of savings, making the household to lose value when consuming their savings in the future, than they would have consumed presently (Burton & Sadiq, 2013:72). This aspect discourages the households from saving for the future. Thus, the major purpose for providing a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers is to eliminate the uncertainties of future value of savings, thus giving the households an open choice on whether to consume the savings presently or save the consumption for the future (Mirrlees, 2008:294). A taxation system that subjects normal returns on saving to taxation does injustice to the households and the tax payers, considering that such earnings on savings principally caters for the delay in consumption (Mirrlees, 2008:292). In this respect therefore, it is important to introduce a savings-neutral system that does not deter the households from saving their incomes for the future consumption. The purpose of the establishment of the savings-neutral taxation system is to create a balance between the present consumption and the future consumption, through ensuring that the present value that would be derived from consuming the income currently still remains the same value when the income is consumed in the future (Hall, 2010:12). The operation of the economic concept of inflation is the major determinant of the future value of current incomes. Thus, the taxation of the savings under conditions where the future rate of inflation is high would mean that the value of the savings is reduced, and thus it would suit the taxpayers and the households to consume the income presently, rather than waiting for the future when it would be of low value (Marr, Huang & Frentz, 2013:n.p.). Consequently, the purpose of establishing a taxation system that is neutral throughout the life-cycle of the savings is to ensure that, whether the households consume their incomes now or saves it for the future, the value now or in the future will remain the same (Mirrlees, 2008:293). The other fundamental purpose for providing a tax system with a neutral treatment of life-cycle savings for the vast majority of taxpayers is to ensure that the vast majority of tax payers have equal opportunities, when it comes to the choice of the assets to invest in (Hausmann, 1997:42). The value of savings is lost where different investment assets are taxed differently, and the taxation system is not supposed to influence whether an individual prefers to save in a savings account, pensions, housing or shares (Mirrlees, 2008:294). Therefore, the purpose of introducing a savings-neutral taxation system is to ensure that different savings assets are taxed uniformly, thus allowing the vast majority of tax payers to have an equal opportunity to save in any assets, since the returns will be taxed equally (Mirrlees, 2008:295). Opinion on the strengths and weaknesses of the proposals Strengths One of the major strengths associated with the recommended proposals to introduce the savings-neutral taxation system is that; the recommended proposals encourages households and taxpayers to save their incomes at a point where either their income is high than the demand for consumption, or at a time when the taxation rate is high, thus it can substantially reduce their incomes (Kahn, 1990:7). This way, the households and the tax payers are able to keep the incomes at the present value throughout the savings life-cycle, and they can eventually consume the incomes when the need arises, or when they will be charged low taxes (Sánchez, 2011:81). Secondly, the strength associated with the recommended proposals for the establishment of a savings-neutral system of taxation is beneficial to the taxpayers, considering that it will create a system of fair and balanced taxation for all individuals, which does not exist in the current taxation system (Helminen, 1999:36). Under the current taxation system, the more the income of an individual fluctuates, the more the individuals are affected by taxation, such that, an individual who earns a fluctuating income between £20,000 and £60,000, annually, whose average is £40,000, will be charged higher taxes than an individual who consistently earns £40,000 (Mirrlees, 2008:305). Thus, the strength of the proposed recommendations is that, they will help to eliminate inequality in the current taxation system. Weaknesses The major weaknesses associated with the recommended proposals is that, unless the marginal rate of tax remains the same, the three proposed approaches for establishing savings-neutral taxation system might not hold (Mirrlees, 2008:306). Consequently, the major weaknesses associated with the proposals is that; a single approach cannot satisfy the tax-neutrality requirement fully, and thus may require a combination of two or more of the approaches (Wise, 1999:65). Another weakness associated with the recommended proposals is that; while the three recommended approaches to achieving savings-neutrality applies to taxation; they do not equally apply to bequests and inheritances (Mirrlees, 2008:307). Therefore, this limitation serves to indicate that the recommended proposals are not universally applicable. Explanation of the type of potential winners and losers of such a move The major gainers in the move to establish a system of taxation that achieves tax neutrality are the households and the vast majority of taxpayers. This is because, the implementation of a savings-neutral taxation system will expand the choice of the household and the taxpayers regarding the choice of the assets to invest in, considering that all investment and saving assets will provide equal opportunities to the taxpayers (Mayshar, 1990:17). Further, the tax payers and the households will gain from the move to establish a savings-neutral taxation system, since they will not lose the value of their savings, considering that under the tax-neutrality system, the present and the future value of the savings will remain the same (Mirrlees, 2008:284). Nevertheless, the losers in this move will be the financial institutions, building societies and the real estate firms, considering that the variable rates at which they charge interests will be scrapped, and instead a uniform charge established. References Burton, M., & Sadiq, K. (2013). Tax expenditure management: A critical assessment. Cambridge: Cambridge University Press. Furman, J. (April 15, 2008). The Concept of Neutrality in Tax Policy. Brookings Educational Research. Retrieved March 6, 2014 from http://www.brookings.edu/research/testimony/2008/04/15-tax-neutrality-furman Gruber, J. (2003), ‘Smoking “Internalities”’, Regulation, 25, 52–7. Hall, R. (2010), ‘The Base for Direct Taxation’, Oxford: Oxford University Press for Institute for Fiscal Studies. Hausmann, R. (1997). Promoting savings in Latin America. Paris: Development Centre of the Organisation for Economic Co-operation and Development. Helminen, M. (1999). The dividend concept in international tax law: Dividend payments between corporate entities. Hague: Kluwer Law International. Kahn, D. A. (1990).The Two Faces of Tax Neutrality: Do They Interact or are They Mutually Exclusive? Northern Kentucky Law Review18, 1-22. Kim, S. B. (2008). A value-added tax (VAT) and the federal income tax reform. Ann Arbor (Mich.: UMI. Marr, C., Huang, C. & Frentz, N. (July 10, 2013).The Problem with Deficit-Neutral Tax Reform. Center on Budget and Policy Priorities. Retrieved March 6, 2014 from http://www.cbpp.org/cms/?fa=view&id=3990 Mayshar, J. (1990). Measures of Excess Burden. Journal of Public Economics, 43, 263-289. Mirrlees, J. A. (2008). Tax by design: The Mirrlees review. Oxford: Oxford University Press. 283 – 317 Sánchez, O., & Palgrave Connect (Online service). (2011). Mobilizing resources in Latin America: The political economy of tax reform in Chile and Argentina. New York: Palgrave Macmillan. Stern, N.H. (1987). Optimal taxation. The New Palgrave: A Dictionary of Economics. Valle, C. L. (2001). Developing government bond markets: A handbook. Washington, DC: The International Bank for Reconstruction and Development / The World Bank. Wise, D. (eds) (1999), Social Security and Retirement around the World, Chicago, IL: University of Chicago Press. Read More