Designing an Efficient Tax System - Essay Example

DESIGNING AN EFFICIENT TAX SYSTEM DESIGNING AN EFFICIENT TAX SYSTEM Introduction A government is obliged to provide certain services to the public and for this to be done it needs revenue. Tax is the main source of revenue for all governments. The largest contributor to tax is the income tax, which accounts for about 47%. Payroll tax, corporate income tax and excise, estate and other taxes account for 34%, 10% and 9% respectively (CBPP, 2014). Revenue collected from taxes is used by governments to finance administration activities, welfare programs and development goals in addition to provision of public goods and services (Enahoro & Jayeola, 2012). An optimal tax system should maximise social welfare subject to a number of constraints, which are the canons of a good tax system (Mankiw, Weinzierl, & Yagan, 2009). To come as close as possible to achieving this goal, a tax system needs to be designed in such a way that it conforms to the following principles: equity. One group of persons or one source of tax should not pay more than is the fair share; certainty. An individual should be able to estimate the amount of tax that is expected of him and the time of pay with ease. The tax authorities should also be able to estimate the amount of taxes that will be collected over a certain period; economic in collection and affordable to the tax payer; and flexibility and adaptability to changes in the economy (Lymer & Hasseldine, 2002) In designing an optimal tax system, most designers adopt the model created in 1971 by James Mirrles. The model presents a trade-off between the equality of a tax system and how efficient it is in meeting the tax objectives (Hillman, 2009). This trade-off is determined by the marginal rates of tax. The best method for achieving this trade-off is in the use of a progressive tax system (Horton & El-Ganainy 2012). However, even in the use of such elaborate and well-tested models of tax policy formulation, the policy makers still encounter a number of difficulties. Formulation of equitable tax system is set back by the fact that both individuals and companies are dishonest in stating the total amount of taxable income that they earn (Malcom, 2009). This is done to evade tax, which is not legal. Understating incomes results in an individual or an entity bearing less of a tax burden than is their fair share and as a result increases the burden on other taxpayers because the desirable tax amounts have to be collected. The government can root this out by putting in place watchdogs and enacting more elaborate measures to ensure that such lies are detected. A more aggressive approach would be to implement tough laws and penalties on those who would be found to have understated their incomes (HMRC 2008). For the policy makers to determine the taxable capacity of a country, adequate data is required from all the sectors in the economy. However, they are not able to obtain all the data they need because the informal sector is characterised by poor record keeping (McCaffery, 2008). In addition to this, the incomes of the people employed in the informal sector are very irregular since they largely depend on seasons (Kato, 2010). The foreign trade sector is also characterised by information gaps which result to inadequacy and inaccuracy of the information obtained (McCaffery, 2008). These three factors makes it hard for the policy makers to determine the taxable capacity of the country which then translates to difficulties in the determination of the tax base and in extension the tax brackets to be used in levying the taxes (Kato, 2010). Creation of a more efficient tax system necessitates intervention by the relevant authorities to enhance availability of information from all sectors. Corruption, evasion of taxes by wealthy government officials and political influence are rampant especially in developing countries (McCaffery, 2008). Some of the leaders use their influence and political power to manipulate the policy makers into enacting policies that are favourable to them but detrimental to the low income earners because more tax burden is shifted to them. Evasion of tax and massive corruption deducts to the amount of tax collected which forces the policy makers to increase the burden on other sectors and groups of people to meet the required amount. This has negative effects on economic development (Acermoglu, 2002). The economy of Greece is almost collapsing owing to the high level of evasion of tax and corruption that is experienced in the country. The high level of corruption and tax evasion has incapacitated the tax system and has resulted bankruptcy of the government (Cambanis, 2014). Curbing corruption is not easy because it is a practice that has its roots in the general integrity levels of a society. However, corruption has to be rooted out in order to ensure the optimality of the tax system and as thus governments need to put in more effort towards eradicating it (Markul, 2005). Disparities in the distribution of income among the citizens of a country makes it difficult to decide on the tax system to be used in order for the government to collect the desired amount of tax and at the same time not overburden tax payers. The level of income of a person can be attributed to personal ability and effort. These two determinants cannot be measured or observed separately (Mankiw, Weinzierl, & Yagan, 2009, p. 5). If the tax policies impose higher taxes for high income earners, it might act as a disincentive to individuals who will then not put in much effort to earn more. However, in conformity with the canon of equity, these high-income earners should be taxed more because they have a higher ability to pay. It is therefore difficult for the policy makers to determine the exact rate of progressiveness of the tax to be imposed (UNCTD, 2007). To facilitate the designing of an optimal tax system, measures will have to be put in place to ensure that resources are more equitably distributed to bridge the gap between the rich and the poor (Page, 2000). Loopholes in the tax laws have made it easy for both companies and individuals to avoid tax. Tax avoidance is legal; however, it results in massive losses in revenue by the government. The revenue loss determined by the deadweight loss that can be calculated using the compensated elasticity of taxable income to changes in the tax rates (Connolly & Munro 1999). One such loophole is the corporate inversions. This is a practice where big corporate avoid paying taxes by buying smaller companies and relocating to areas that are considered tax havens (Ryan, 2014). This loophole can be sealed by revision of the relevant laws to ensure that the level of tax evasion is reduced. A person bearing the incidence of an indirect tax can shift the impact to a different person or group of people. Value added tax is one such tax. Suppliers, who bear the incidence of the tax, can shift the tax forward to transfer the impact to the consumer through increased prices (Entin, 2004). The amount with which the tax can be shifted to the consumer is not standard for all commodities; it is dependent on certain factors such that suppliers can either shift the entire tax burden to the consumer of a portion of it (Entin, 2004). In some instances, the suppliers bear the entire burden or shift it backwards to the manufactures. One such factor is the price elasticity of demand. This is the responsiveness of demand to changes in own price of a commodity (Hirschey, 2008). A consumer will bear the entire tax burden if the demand for that particular good is perfectly inelastic. When the demand is perfectly inelastic, the quantity of goods demanded remains stable despite changes in prices. This type of demand is associated with necessities such as staple foodstuffs and habitual goods such as cigarettes. In this case, the suppliers can shift the tax burden by increasing the prices of the goods and suffer no loss in the volume of sales because the demand is barely affected. However, if the demand is elastic, the supplier will have to determine a trade-off in the sharing of the burden because shifting the entire burden to the consumer will result in loss of revenue through decreased sales (Entin, 2004) Lump sum and regressive tax systems are rarely used because they violate the canon of equity. Their use will impose a higher burden of tax on the low-income earners (Mankiw, Weinzierl, & Yagan, 2009, p. 4). It is equitable that people pay taxes according to their ability to pay which is reflected by their income levels thus the common use of the progressive tax system. Under this system, the amount of income tax paid by a person is directly related to their level of income (Hillman, 2009). However, due to the complexity of the tax system and other economic variables, this is not always the case as there are some instances where low income earners pay higher taxes relative to their incomes as compared to high income earners (Dalsgaard, 2000). Therefore, if the government wishes to reduce the taxes paid by low income earners, it would need to implement or strengthen certain policies. Marginal rates of taxes that are tailored to match the abilities to pay of the tax payers will ensure that low income earners pay less tax as compared to those who earn higher incomes. High income earners are few as compared to the low income earners and it is for this reason that marginal tax rates can be applicable in reducing the tax burden of the poorer people. An effective marginal tax rate is that which affects a minority group and thus tailoring the marginal rate to the abilities to pay will be an effective policy (Mankiw, Weinzierl, & Yagan, 2009, p. 6). The government could introduce tax waivers on the value added tax that is levied on necessities to reduce the tax burden to low-income earners (Salanie, 2011). Tax waivers on such commodities would reduce their prices and thus act as a relief on this group of people. However, this is not discriminative; the wealthy people will also pay less for the same products. This can be counteracted by increasing the rates of taxes on leisure activities and their complements. The amount of leisure that one consumes is directly proportional to the level of income and thus higher income earners will pay more in taxes because they consume more leisure (Connolly & Munro 1999). The government can diversify its sources of taxes to the decrease the portion of taxes that is collected from incomes. As much as cumulative decrease in the amount expected from income taxes reduces the tax burden on all income brackets, the lower income earners benefit more due to the aspect of marginal tax rates (Mankiw, Weinzierl, & Yagan, 2009). Another way of reducing the burden of on low-income earners is through curbing of corruption in the government. Millions of dollars are lost annually in the hands of corruption and misappropriation of funds. Cutting down on this figure means, the government spends less and hence reduced revenue needs (Markul, 2005). Conclusion An optimal tax system is imperative for any government as it is the main means by which revenue is earned. It ensures that there is balance between equity and efficiency of the taxes collected such that the people do not feel oppressed by high taxes and the government is able to collect enough revenue to facilitate its running. For this reason, governments should invest in the development of a tax system that will meet the financial objectives of the country. In doing so, the relevant tax authorizes should also ensure that the system is fair and instrumental in achieving the economic goals (Kaja, 2012). Reference Acermoglu, D., 2002. Technical change: inequality andthe labor market. Journal of economic literature 4, 7-72. Cambanis, T., 2014. Why can`t Greece shake its corrruption problem? [Online]. Available at: www.bostonglobe.com/ideas/2014/08/22/why-can-greece-shake-its-corruption-problem/6nwZglU9cmn70xg2x4sobM/story.html [Accessed 22 November 2014]. CBPP., 2014. Policy basics: where to federal tax revenues come from? [Online]. 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