International Taxation: Policy and Practices - Example

International Taxation Contents Introduction 3 Discussion 4 Cannon of Equity 5 Cannon of Certainty 7 Cannon of Convenience 9 Cannon of Economy 9 Conclusion 11 References 13 Introduction International taxation is the theory of determination of tax rate on a person or business, subject to the tax law of individual countries. Mainly, Government imposes tax on the income of individuals, corporate & enterprises. The system of taxation does not follow any international standard and the scope for no taxation or double taxation where individuals are expected to pay more than once for the same income increases widely. In general, reduction of tax or foreign credits within a specific limit is allowed to the international tax payers to reduce worldwide tax liabilities of international players and specially Multinational Corporations (Kobetsky, 2011). Most of the countries in the globe follow two systems of taxation on income. Territorial where only the income from sourced from inside the country is taxed. Residential where income of individual or business, sourced from both local and foreign trades and services are taxed. Though in most of the countries, non residents are taxed only on their local income, few countries like the United States impose tax on the worldwide income of non residents as well (Kobetsky, 2011). In countries with residential tax payment system, deductions are granted for the tax payers who are already paying taxes to other countries on their foreign income. As a result of liberalization & rapid expansion of international trade, many countries are coming together to sign tax treaties to eliminate the possibilities of double taxation. In 2011, present Governor of Texas, Mr. Rick Perry proposed a flat tax rate of 20% in US. The flat tax system may be defined as the tax system in which everyone pays the same tax rate, irrespective of their income (Kobetsky, 2011). Rick Perry proposed a simple tax structure of 20% flat tax on individual income minus exemption & deduction of mortgage interest, dividends, charitable income, capital gains, state tax etc and a 20% flat tax on net income of corporate less dividend payment & foreign earnings. In this paper, the implication of imposition of such tax policy will be evaluated (Helminen, 2010). Discussion Flat taxation system is a widely debated factor. Some of the scholars explain the flat tax system to be fair mainly on the ground of its possibility to eliminate tax credits, deductions & exemptions, thus creating an unbiased tax system (Kobetsky, 2011). Elimination of such factor leads to generalization of tax structure & easy compliances. Flat taxation also aims at removing double taxation by imposing tax only on the income earned. This tax system also ignores income from interest on savings, capital gain on existing investments or value of asset, dividends etc. This enhances the scope for investments as well. Another argument given to support this taxation system is that the tax structure encourages productivity & more income thus accelerates economic growth as higher income is not penalized by higher tax slabs. So, per capita income of those high net worth individuals increases after paying tax, which broadens the investment avenues (Smith and Maloney, 2012). The main objective of Rick Perry behind imposition of such tax policy is to stimulate job market in the economy. According to him, cutting corporate tax from 35% to flat 20% level and elimination of tax on foreign earnings will lead to a flow of job opportunities from overseas towards the country itself and hence, create enormous opportunities in domestic job market (Helminen, 2010). Simplification of tax structure & reduction of complex compliance system and tax collection were other aims for such implication of tax (Smith and Maloney, 2012). To establish the verification or applicability of Rick Perry’s flat Tax system, the concept should be evaluated in terms of Adam Smith’s Cannon of Taxation (Helminen, 2010). Adam Smith’s Cannon of taxation is regarded as one of the best classic explanations of taxation in economic theory. Considering the time frame when growth of trade was at its beginning to put emphasis upon random convention, free trade and natural law prevails in the economy and national wealth was simply the aggregate of all individual wealth, the concept of the theory still holds great influence (Smith and Maloney, 2012). The four cannons of Adam Smith were as follows: Cannon of Equity In this theory, Smith explained equity as equality, justice & fairness. Here, equity does not mean that same tax rate should be imposed on all individual of the nation. Rather, tax burden should be distributed according to the capacity of tax payment (Helminen, 2010). These cannon, however, is supported by two theories: (i) Equality of sacrifice Theory: According to this theory, tax burden should involve equal sacrifice for every individual. However this concept of sacrifice, being subjective, holds well in theory but not in practice (Smith and Maloney, 2012). Number of factors such that standard of living or mindset of people should be taken into consideration which is impossible to quantify. (ii) Ability or Faculty Theory: The ability theory depends on the ability of the tax payer to pay the proportion of income as tax. This implies, that high earning individuals are supposed to pay more than the low earning individuals (Smith and Maloney, 2012). (Helminen, 2010) This principle, in contrast to Rick Perry’s flat taxation, largely supports progressive taxation. Progressive taxation is a tax structure where as the taxable income of individual or business increases, the rate of tax also increases. This low to high tax bracket approach gives rise to high marginal tax rate of an individual as compared to his average tax rate (Smith and Maloney, 2012). The main idea of Rick Perry to introduce flat tax system in US, 2011, was to shift the tax implications away from rich to poor & middle class. But following Adam Smith’s theory, it can be said that, the idea of such imposition may not proved to be sound for individuals and the economy as a whole as this tax system will indulge extra burden on the low income tax payers, their disposable income will decrease, eventually standard of living will fall. Similarly, due to lower tax imposition on high income group, the marginal utility of dollars decreases as income increases (Kim & Varsano, 2006). Cannon of Certainty Cannon of Certainty may be explained as the individuals should have complete idea of when to pay tax, at what rate & on which part of his income. Similarly, the administrative bodies of the nation should have a fair idea about tax collection, regulations & compliances. As per US tax structure before 2011, imposition of progressive tax on income had its inherent difficulties. US Government expenses too much for imposition tax rule & collection of tax. Tax rates were too high & complex in nature. It also involved a large number of flaws; self interests played an important role in tax evasion. Moreover, most of the tax payer didn’t have complete or partial information of when to pay tax & at what rate (Kim & Varsano, 2006). Compliance structure was also complex. According to sources, the US Government was supposed to expend as much as $320 billion, only on compliances & tax collection, the expense that could have been shifted towards social & cultural improvement of the country. In such circumstances, Rick Perry came with the opinion that such expensive tax system is unrealistic for the economy. Besides that, in spite of spending such a large amount of money for this purpose, probability and incidents of tax evasion may prove to be very uneconomic for the country. However, considering the amounting debt in Government’s account, according to Perry, carrying such huge burden in terms of tax collection & compliances will become unsustainable in long run (Kim & Varsano, 2006). (Kim & Varsano, 2006) Therefore, as per Adam’s Cannon of Certainty, Perry’s proposition for imposition of Flat tax holds good. Flat tax is easy to understand for general people. Its ability to comply with reduces the probability of tax errors & tax fraud. Due to presence of perfect information as to when & how much to pay tax, intervention of professionals is no more required, thus saving money for the tax payers. Due to elimination of complexity in tax structure, areas of personal interests or creating ambiguity go in vain. So, considering all such factors of Adam Smith’s certainty, flat tax proposition of Rick Perry is a good option (Kim & Varsano, 2006). Cannon of Convenience According to Adam Smith’s theory, tax should be collected according to convenience of the tax payer. He established this proposition based on the fact that, in India, land revenue was realized after harvests had been collected (Kim & Varsano, 2006). But in today’s economy, with a complex business structure, existence of international trade, presence of overseas services and individuals’ and corporate intension of reducing or erasing tax liability as much as possible, the concept of leaving tax collection on tax payers’ convenience becomes highly unrealistic. They say that the two main truth of life is tax & death. No one wants to realize them (Gravelle, 2011). Even if we talk about convenience, progressive tax structure is much more convenient for middle & lower class of tax payer than flat tax rate. Flat tax system proposed by Perry may serve interest of big corporate and rich individuals, but from the point of view of maximum resident tax payers, who fall into medium or low income group, imposition of extra tax burden due to flat tax rate will create high level of inconvenience among them (Gravelle, 2011). Cannon of Economy Cannon of Economy implies that the cost of administration & collection of cost should be as low as possible. Tax is an income for Government used for running the economy of the country effectively and addressing each and every problem of the country. Hence, if a large chunk of tax is spent on collection of tax then two situations may arise. Either government will raise the rate of tax to meet government’s expenditure or government will ignore the issues into the country that requires attention (Gravelle, 2011). According to Smith, if the tax structure involves large administration & compliance cost, it is not a wise decision for the nation to continue with the same tax structure. Rick Perry also took initiative to impose a flat tax structure on the ground that the huge administrative cost involved with the existing tax structure and the misconducts going on to avoid tax or accomplish self interest in this area leads to huge opportunity loss for the government and if the government continues with the existing structure that may lead to a gross deficit in government’s fund which may create irregularities even in payment of bills in international trade (Perry, 2011). Talking about real world evidences, a large number of countries have taken flat tax structure during their tax reforms & have experienced a very positive outcome (Gravelle, 2011). Flat Tax structure have resulted in accelerated economic growth, reduced unemployment level & easy tax compliance. Nations like Estonia & Slovakia first showed the global economy the risk free propositions of such tax reforms. Hong Kong has also shown marked progression as a result of adopting such tax structure. They have been able to source 16% of the nation’s income from such tax implication. Countries like Albinia, Czech Republic are also enjoying benefits from reform of their tax structure. Russia’s tax reform gave rise to earnings of the government but inequality had lesser effects on the economy. Ukrine imposed 13% flat tax whereas Georgia introduced a 12% flat tax rate on their residents. Understanding the positive effect, many developing countries are considering this tax structure in their upcoming reforms (Kim & Varsano, 2006). However, it is not desirable to draw conclusion about applicability of flat tax in United States, only on the basis of incidents of these nations. Evident are also there where countries with flat tax rates are competing to lower their tax rates. Estonia had started decreasing their flat tax rate from 22% to 18% in 2011, when US was just considering the proposal (Perry, 2011). Lithuania had also reduced their tax rate from 27% to 24% where Macedonia scheduled a rate cut of 9% in 2010 as against their existing tax rate of 10% at that time. Hence, according to International Monetary Fund reports, adopting flat tax system is pushing the nations in a tax competition that drives the tax rate even lower (Gravelle, 2011). Conclusion It seems that, there is no doubt that those countries, who have adopted flat tax rate, are showing a sound economic expansion, resulting in a booming economy. But there is no strong evidence to prove that flat tax is the only or most important reasons for national growth. In other terms, flat taxation does not provide scope for wealth distribution for the benefit of the society. Rather, it imposes extra tax burden on the lower & middle class of the society. Flat taxation also influences the purchasing power & investment decision of an individual. If a flat tax of say 18% is imposed on a person with an income of a million per year, he is still left with $8, 20,000 which is his investible surplus. And above all, his income from this investment is tax free which leads to accumulation of huge tax free net worth (Bishop, 2004). So, in turn Government is losing out potential revenue from this part of the society. But, in case of a person with $50,000 annual income, imposition of flat tax rate of 18% will affect his standard of living, fiscal decisions like purchase of car or own house & affording luxury items, leaving no room for him for investments to secure his future. In addition, the countries those have already adapted flat tax, are now running towards reducing their tax rates (Bishop, 2004). Decreasing tax rate not really serve Government’s purpose of increasing revenue. But decrease in non-refundable income in lower & middle income group of the society results in fiscal instability. During 2008-2009, many countries following flat tax rate had suffered a lot due to recession, as individual income, especially those engaged in service sector had reduced radically. For instance, Latvia’s economy fell by 12% in 2009; its debt amounted to 116% of its GDP & unemployment rose to 9%. The country had to call for a bailout from International Monetary Fund in order to run workings of public sector (Gravelle, 2011). From the discussion of Adam Smith’s Cannon of Taxation inference should be drawn that Rick Perry’s proposition of flat taxation holds good only in ideal economic situation (Bishop, 2004). Tax Cannons like equity & certainty does not hold good for Perry’s concept of flat taxation. Though, flat taxation structure is arguably convenient from both Government & individuals’ perspective, it is not a big criteria for a country to introduce a new taxation or consider the factor into their tax reform. Yes, Economic efficiency is a big factor in terms of Government revenue & cost consideration. From the above stated arguments and counter arguments it can be stated that the flat tax rate is not convenient as such. References Bishop, E., 2004. Finance of international trade. Oxford: Butterworth-Heinemann. Gravelle, J., 2011. Reform of US international taxation: alternatives. New York: DIANE Publishing. Helminen, M., 2010. International tax law concept of dividend. Amsterdam: Kluwer Law International. Kim, K. & Varsano, R., 2006. The "flat tax(es)": Principles and evidence. Washington D.C: International Monetary Fund. Kobetsky, M., 2011. International taxation of permanent establishments: Principles and Policy. New York: Cambridge University Press. Perry, R. 2011. My Tax and Spending Reform Plan. [online]. Available at: http://online.wsj.com/news/articles/SB10001424052970204777904576651330270547222. [Accessed on 17th November, 2014]. Smith, J. & Raabe, W & Maloney, D., 2012. South-western federal taxation 2012: taxation of business entities. Ottawa: Cengage Learning. Read More