What Factors Need to Be Taken into Account When Designing a Tax System - Coursework Example

What factors need to be taken into account when designing a tax system? The concept of taxation is a crucial factor for the well functioning of a welfare state. The taxes are collected by the state not only to accumulate revenue for financing public expenditure but also for the sake of economic stabilization, securing an equitable distribution and efficient resource allocation. Taxation acts as an effort to stabilize economy by the stabilization of price, wage, employment and balance of payments. Government efforts are made to secure an equitable distribution of income and wealth of the economy and last but not the least tax is machinery in the hand of the government which is essential for optimal allocation of the resources of the economy. While a tax is imposed it somehow hampers the free market operation and hence tax is subject to some social cost. Thats why an efficient taxation should minimize the social cost or welfare loss. On the other hand it should target to encourage the saving and investment in the society. According to Adam Smith, the tax structure should be fair and clear enough i.e. everyone should have the information regarding the tax that is paid and the administration of the tax system should be clear and easy. While a tax is introduced the following facts should be kept into mind. 1. The tax system should be economically efficient i.e. the benefit of taxation should exceed the social cost of it. The benefit includes the correcting effect, allocation of resources and insurance of equality. 2. The tax system should possess administrative efficiency. It should be easy to monitor and maintain and the system should be simple enough so that the administrative cost and the compliance cost are minimum. 3. Flexibility is a desired feature of the tax system. It should be easy to change the tax structure along with the changes in social and economic needs of the country. 4. There should be close coordination between the political decision makers and the tax system. It implies that tax payers should have the perfect knowledge about the mode of operation of the taxation system and the political decision makers should be well aware of the preference of the people so that the change in decision must be the resemblance of the choice of the majority of the tax payers which is a basic feature of a democratic system. 5. The conventions ruling the tax system should be fair and justified so that no bias is reflected in taxing. (Adam Smith on Taxation) All the aforesaid features are closely related to a fair distribution and the economic benefit of the taxes. Beneficial tax normally refers to the optimal taxation. The optimal tax theory is based on the equality and the economy of collection of taxation. While any government frames a taxation policy it should keep into mind that the taxation should be socially justified and have minimum impacts on the economic decisions. A wide array of social welfare functions should be considered to clarify the well being. The matter of fact is that the social welfare is not the sheer summation of the individual utilities. Ultimately what matters is how the utility is distributed within the society. According to the economists a rise in the inequality is synonymous to the loss of social welfare. Social welfare should resemble the conception of economic justice and clarity. According to the economic literature an optimal tax is the taxation that brings about an improvement in social justice and equity. If we consider the distributional preference as a part of social welfare the social welfare is represented by the attainment of social justice. (Public Finance: Section 2) Now the question arises how the concept of fairness can be used for determination of the optimal taxation. Thats why the two separate concepts of fairness are introduced: the horizontal and vertical equality. The horizontal equity refers to the equal treatment received by the people characterized by the presence of the same circumstances. The vertical equity means the fairness among the treatments received by various people in various circumstances. The circumstances that we mention here should contain the income as a flow concept and wealth as a stock concept. Still, there is no way to define the income and wealth for the tax purposes. Horizontal equity is characterized by the fairness among people belonging to the same income and wealth group; but it would be wrong to expect that the people having same income and wealth would be subject to the same amount of taxation (for example under the same economic condition the consumers of alcohol is subject to higher taxation). The concept of vertical equity is that the people with higher income and wealth have to pay tax than the people having lower income and wealth. Basic principle o taxation lies in the fact that the taxes should be simple enough so that the people who are affected by tax can easily realize. That should be subject to minimum cost of collection. Moreover, there should be minimum harmful dispersion from the market equilibrium. Taxes have no direct benefit to the incumbent person. Actually it is used to finance the government expenditure which is used in different welfare projects such as public distribution system, education for poor children etc. Taxes are the instrument in the hand of government for the redistribution of income and wealth. Moreover, the taxes are used to finance the expenditure of expansionary fiscal policies to secure income and employment of the country. Overall, taxes are used for a number of public operations or public intervention in order to attain a number of objectives. However, there is nothing to be astonished that a conflict among the policy objects causes a dilemma regarding the good taxation system. The improvement of social welfare through public intervention is partially dependent upon the taxation of the economy. Thats why the conceptualization of the good taxation system is highly needed for the sake of realization of the welfare system. There are two approaches of taxation regarding the distribution of tax. The benefit approach of taxation is based on the microeconomic analysis of public finance which examines the cost and benefits of the public sector activities enjoyed by the citizens or the voters. According to the theory of utility we know that a consumer’s equilibrium level of consumption is achieved while the marginal utility of consuming the good equals its marginal expenditure on it. According to this theory every individual should pay for the public good according to the marginal utility that he derives from the consumption of that particular commodity. This is known as the benefit principle for taxation which is based on concept of consumer equilibrium derived from the theory of utility. This is normally a market based approach of taxation. This benefit approach based on the inclusion of the voluntary exchange approach in the literature of public finance is subject to drawbacks on the ground of equity and justice. First of all this taxation principle is far from reality especially under the circumstances where the tax is coercive and compulsory. If the principle of taxation is based upon the marginal valuation of the benefits what they enjoy from the public goods in order to escape the taxes they would definitely under record the utility that is yielded by the commodity for them. So the ultimate consequence will be the free rider problem. Moreover the principle of redistribution of income is wealth is completely neglected. The efficient allocation of taxes would be based on the voluntary exchange approach and the matter of fact is that the poor people are the major beneficiary from the public goods. So according to the benefit approach the distribution of tax would be regressive. (Public Finance: Section 9) In the early 20th century there had been a change in the designing of the tax system. The economists were much concerned with the minimization of public expenditure and hence minimizing the burden of taxation from the people. The establishment of social justice in the taxation system gained huge importance. There was the emergence of the ability to pay approach. According to this approach the distribution of the tax burden is not based on the benefit that a person derives from the public goods or the regressive taxation. Rather a new approach was introduced to establish social justice or equitable distribution. The preference of the government was based on imposing the taxes on the incumbent according to his capability to afford it. The main essence of this principal is dissimilar treatment for unequal and the similar treatment for the equal people. Of course this equality was subject to the income and wealth with which a person is endowed. This equity principle of taxation is based on the core concept of social justice and fairness. The equality in the burden of tax is synonymous to equality regarding the sacrifice. That is a new conceptualization of justice in the literature of public finance. For the sake of justice the ability to pay approach could be based on a proportional taxation. Whenever we call for the case of equality if the poor and the rich are subject to same amount of taxation the loss of welfare for that amount is much higher for the poor than a rich man. So the equality of sacrifice should be considered in different way of taxing the people to maintain the equality. Thats why the concept of equal absolute sacrifice and the equal proportional sacrifice emerged. Equal absolute sacrifice refers to the taxation while both the poor and the rich people face same level of loss in total utility for paying the tax. On the other hand equal proportional sacrifice implies that the proportional loss of utility due to taxation should be same for all the individuals of the society irrespective of the economic condition. Another concept is there regarding the equality or justice that is the concept of equal marginal sacrifice that refers to the fact the income should be reduced from the hand of each so that the marginal utility of that income remains same for everyone. (Desirable Features of Taxation) What are the social benefits of taxation? The taxation can sometimes increase the social welfare by distorting effects in the cases of market failure. Such kind of welfare accrues to the whole society especially in the case of externality. For example we consider a private enterprise that causes pollution in the environment. In this case the market system can’t solve the problem of pollution as the quality of air is not a marketed commodity. Hence the social cost of production is higher than the private cost. On the other hand the entrepreneur reaches his equilibrium while the marginal private cost is equal to marginal private benefit. So the level of production becomes suboptimal considering the problem of pollution and the market system cannot solve it. Then the government can solve the problem through taxation. While there will be partial tax to the extent of the difference between marginal private cost of production and the marginal social cost of production then the production would be decreased and the optimal level of production would be attained. In such a case the distorting tax acts as the corrective measure in solving the problem of pollution which is a social evil. That can be shown with the help of the following figure. Benefit, Cost MPB MSC A G MPC E B 0 D F quantity In the above figure the horizontal axis measure quantity and the vertical axis measures the cost and benefit of production. MPB is the marginal private benefit curve and MPC is the marginal private cost curve. MSC is the marginal social cost curve. The vertical difference between MSC and MPC describes the cost of pollution. The socially optimal level of production is 0D determined by the intersection of MPB and MPC curves. But the producer produces according to the equality of MPB and MPC. The private optimum point is E and quantity is 0F. 0F is the sub optimal level of production as the market does not include the cost of production. What the government can do now? The government can impose a partial tax on the on the product to the extent AB/unit. Hence the marginal private cost will be equal to marginal social cost and the equilibrium is achieved at point G and the socially optimal level 0D is produced. (Partial Equilibrium Analysis of Taxation: Taxes on Single Industries) After the social welfare and the distribution of tax we need to consider the cost and the burden of taxes. That does not simply imply the amount of tax as the expenditure of the incumbent. Beyond that an economy has to bear some cost of tax. For example the economy has to face a cost of administering the system for the proper collection of tax which is known as the administrative cost of taxation. Tax authorities have to bear the burden of this cost. If the taxpayers are honest enough then the cost of monitoring the system is low and for the dishonest taxpayers this cost would be high. On the other hand the taxpayer has to pay some cost on the legal advice that they seek from the tax professionals. Such kind of cost is known as compliance cost. Beyond these traditional costs or what we may call transaction cost there are some costs which take place due to market distortion created by taxation. Such types of cost are known as the efficiency cost or deadweight loss of taxation. Why such deadweight losses take place? Simply because of the fact that taxation causes a change in the relative price and that’s why the market decisions are changed. Many time both the production and consumption move from the optimal to sub optimal level. Thats why there is a fall in welfare for both the producer and the consumer. Such loss in welfare is known as the deadweight loss or social cost of taxation. One part of measuring the loss of social welfare by taxation is familiar as the marginal efficiency cost of taxation. This measure the impact of one additional unit of tax measured in terms of national welfare or the social welfare. Actually the social welfare of a country is arbitrarily represented by the national income and the marginal efficiency cost measures the change in national income for one additional unit of tax charged. That is nothing but a multiplier effect. This approach was developed by the Harvard University economist Dale Jorgensen and his colleague Kun-Young Yun. (Cost of Taxation) Whenever a tax is imposed it has normally a direct negative effect on the economy as well as on the individuals (only except the case of externality). But taxation is required mainly to finance the public expenditure which is intended to secure national welfare and equality. So tax should be chosen on a cost benefit analysis. Read More