Taxation, a system of compulsory contributions levied by a government or other qualified public body on people, corporations, and property, in order to fund public expenditure. In deciding whom, what, and how much to tax, all governments have economic and social objectives. Some types of business activity or product, such as cigarettes, may be discouraged by heavy taxes. Other businesses, such as those operating in depressed areas, may be encouraged by tax breaks. Or taxation may be used to bring about social reforms through altering the distribution of wealth.
The effectiveness of any government, at the central or local level, depends on the willingness of the people governed to surrender or exchange a measure of control over property in return for protection and other services. Taxation is one form of this exchange.
II HISTORICAL DIFFERENCES
In medieval times, taxes were customarily paid not in money but in the form of labour or other payments in kind (such as work on local roads or supplies of grain or other farm produce). As long as the government’s services consisted largely of military actions and the provision of roads and other public works, this form of taxation satisfied most governmental needs reasonably well. Rulers could require feudal lords to provide, as a form of tax, workers or soldiers in numbers that reflected the noble’s rank and wealth. In the same manner, grain levies could be imposed on landowners, both to feed the workers or troops and to provide for other government needs. In modern industrial nations, although taxes are levied in terms of money, the fundamental pattern remains: the government designates a tax base (such as income, property holdings, or a given commodity); applies a tax-rate structure to the base; and collects the tax (equal to the base multiplied by the applicable rate) from the stipulated legal taxpayer.
Tax systems, even today, are as varied as the nations that devise them, ranging in complexity from the most basic arrangements to computerized revenue systems. Simple tax mechanisms are suitable only to the needs of those governments that are extremely limited in scope. When government responsibilities are extensive and diverse (as, for example, when taxes are used to modify economic inequalities and to distribute benefits in ways that are considered equitable), the underlying system of taxes must be sophisticated. Elaborate networks of fiscal reporting become essential, as do legal enforcement and a standard of public education adequate to ensure a high degree of taxpayer compliance.
III PRINCIPLES OF TAXATION
Tax systems perform differing functions, depending on the responsibilities expected of the enacting government. Local governments traditionally depend most heavily on property taxes and central governments on sales taxes and income taxes. Local governments are required to keep their expenditures within the budgetary limits, determined by their own revenues augmented by payments received from central government, though in some circumstances they can borrow money. The central government, however, can borrow or even create money; it does not have to raise enough from its tax system to balance its budget. Taxation is also the basic instrument of fiscal policy. In concert with its control over the money supply (that is, its monetary policy), the government aims to maintain the stability of the economy. In depressions, for example, taxes may be lowered and budget deficits incurred so that consumers will have money to buy goods and investors will have capital to put into the industry, thus stimulating production. In prosperous times, tax increases may be needed to hold down or prevent the inflation caused by too much money chasing too few goods, or if the government prefers to control inflation through interest rates, taxes may be cut for political or other ends.
Among the tax systems of different nations, wide variations exist in how money is raised and spent. Tax and expenditure policies reveal the fundamental ideology of a government and a political system. Most democracies today derive their general notions of what constitutes a good tax system from four principles enunciated in the 18th century by the Scottish economist Adam Smith.
Of fundamental importance is that any tax must be fair—that is, citizens should be taxed in proportion to their abilities to pay (a concept that Smith defined somewhat ambiguously as “in proportion to the benefit they derive from the government”). A tax is considered fair if those who have the means to pay are assessed either in proportion to their capacity to pay or, depending on the situation, in proportion to what they receive from the government. Both “ability to pay” and “benefits received”, therefore, are criteria of fairness. When government services confer identifiable personal benefits on some individuals and not on others, and when it is feasible to expect the users to bear a reasonable part of the cost, financing the benefits, at least partly, by taxing the people who benefit is considered fair, as in the repayment of loans to students by subsequent taxation. (Obviously, this method does not apply to such services as public welfare payments.) Taxation in accordance with appropriately applied standards of ability to pay or of benefits received is said to meet the requirements of vertical equity (because such taxation exacts different amounts from people in different situations). Just as important is horizontal equity—the principle that people who are equally able to pay and who benefit equally should be taxed equally.
B Clarity and Certainty
The application of a tax should be clear and certain. This principle, considered very important by Smith, has often been underestimated in modern tax systems (in which open and impartial administration usually can be taken for granted). Where the application of taxes is uncertain and arbitrary, however, the public can have no confidence in the system. The old British tax on numbers of house windows was disliked and widely resisted partly because its rationale was unclear; likewise, windfall taxes introduced by a government on gains produced by the policies of a previous government can appear uncertain.
Taxes should be easy to calculate and collect. Compliance with income tax laws increased dramatically where a system of deducting tax from earnings before they are paid has been introduced.
A good tax system should be structured so that it can be administered efficiently and economically. Taxes that are costly or difficult to administer divert resources to non-productive uses and diminish confidence in both the levy and the government. Worse still, waste can also be created by excessive tax rates; economic efforts are then shunted from high- into low-yielding activities, from productive enterprises into tax shelters, and from open, above-board transactions into hidden, off-the-record participation in the underground economy. When this happens, the important principle of tax neutrality (which maintains that a tax should not cause people to change their economic behaviour), implied by Smith, is violated.
Smith’s tax maxims have stood the test of time remarkably well. Other basic principles have been added to the list, but some have occasionally been proven counter-productive. An example is the desirability of tax elasticity—that is, the automatic response of taxes to changing economic conditions without adjustments in tax rates.
IV TAX BASES
In designing tax systems, governments customarily consider three basic indicators of taxpayer wealth or ability to pay: what people own, what they spend, and what they earn. Historically, agriculture, as the fundamental basis of the subsistence economy, became the earliest lucrative tax base. Thus, among major revenue sources, the property tax on land and its produce is the oldest of modern taxes.
The movable property was somewhat harder to tap as a source of taxation, but as marketplaces developed, taxes on the sale or transfer of goods became productive sources of revenue. International commerce gave rise to customs duties, levied both to yield revenue and to control the amount and kind of imported merchandise. Domestic trade spawned a variety of taxes, ranging from excises on specific commodities (such as the ancient salt tax) to levies aimed at taxing designated transactions. An example of the latter, still widely used in some parts of the world, is the stamp tax on bills of sale and other legal and financial documents. (The stamp tax levied by the British government on American colonists became so prominent as a symbol of tyranny—of “taxation without representation”—that it helped trigger the American War of Independence.) Also widely used today are excise taxes of many kinds, especially on luxury items and on goods such as alcohol and cigarettes, the use of which governments wish to regulate. Many countries levy sales taxes at the retail level. To lighten the burden on the poor, countries exempt necessities such as food and prescription drugs. European Union countries use a value added tax, levied on goods and services, at each stage of production, on the value added at that stage.
Although the value added tax is comparatively new, taxes on what people own, buy, transfer or use have a far longer history than doing taxes on what people earn or otherwise receive in income. A personal income tax was first used in Britain in 1799. It was dropped for a time and then revived, and has been in continuous use in Britain since 1842. Because an individual income tax is complex and difficult to administer, this kind of tax was slow to take hold. By the end of the 19th century, however, a number of countries in Europe and elsewhere had adopted it. In the United States, the 16th Amendment to the Constitution (ratified in 1913) was needed to establish the legality of a federally imposed income tax.
V EFFORTS TO ACHIEVE FAIRNESS
Because no single form of wealth is a perfect indicator of taxpayer ability to pay, most modern nations try to diversify their tax systems. Many people think of the ability to pay largely in terms of income. This assumption, however, is losing ground as the inequities in modern income tax systems become increasingly apparent. Inheritance tax on bequeathed wealth has also come under considerable criticism. A comprehensive form of taxation on consumption expenditures has gained support among tax specialists, but public acceptance has been lacking.
No tax is levied with perfect evenness or on a completely comprehensive base; its burden inevitably falls more heavily on some taxpayers than on others: this unfortunate fact exacerbates the basic unpopularity of taxes per se. The exemptions, exceptions and other loopholes in tax laws are partly the result of humanitarian concern for those who might be overburdened; partly, they reflect political pressures; and partly, they come from administrative inefficiency or inability to deal with the extremely complex tax structure, or to foresee all possibilities for tax evasion. By using a variety of taxes, governments can attempt to ensure that the tax burden falls fairly across all taxpayers.
As governments find it ever harder to finance all their commitments, and as taxpayers grow ever more resentful of the taxes they are asked to pay, interest has grown in levies designed to achieve fairness in terms of benefits received. Aside from simple user charges such as those on public leisure amenities (which may be thought of more as prices than as taxes), the benefits standard is apparent in many major levies. These include petrol taxes that are earmarked principally for road maintenance and construction; business levies collected to provide unemployment insurance; and social security taxes allocated to worker casualty insurance and retirement funds. The effectiveness of earmarking is a much-disputed issue, but it tends to appeal to politicians, though in fact all revenues are generally pooled regardless of national earmarking. Although earmarking can make raising new revenue easier, it can also create budgetary distortions, especially in times of economic stress, when the general fund may be in need while special funds are more than adequately filled.
VI TAX INCIDENCE
The effects of taxation are difficult to judge. Even personal income tax, which is presumed to fall entirely on the legal taxpayer, has indirect consequences in the economy; it influences decisions to work, save, and invest, and these decisions affect other people. Corporate income tax may in some cases simply result in lower corporate profits and dividends; in other cases, it may broadly reduce the incomes of all owners of property and businesses. To the extent that corporations compensate for the tax by raising the prices of their products, the tax burden may simply be shifted on to consumers. To the extent that tax-reduced corporate profit margins hold down wages, the incidence of the tax is shifted backward to workers.
Similar disagreements arise over the incidence of local property taxes and over the employers’ share of social security payroll taxes. Even the long-established view that retail sales taxes are shifted forward from retailers to consumers is challenged in a world in which wages and government transfers (that is, income payments such as social security) are indexed, or automatically adjusted upward, for inflation. The inclusion of the sales tax in the Retail Price Index insulates recipients of indexed incomes against inflation-induced tax increases and therefore puts the burden of those increases on the recipients of non-indexed incomes. As awareness grows of the difficulties in pinning down the burden patterns of various taxes, the old distinction between direct and indirect taxes becomes relatively meaningless.
VII OTHER EFFECTS OF TAXATION
Despite the difficulties of precise measurement, governments are appropriately concerned with the vertical pattern of the tax burden: does it fall proportionately more heavily on the rich than on the poor (progressive taxation)? Does it burden everyone to the same degree in relation to taxpaying ability (proportional taxation)? Or does it place a relatively heavier burden on the poor (regressive taxation)? In most modern nations, a generally progressive tax structure is considered desirable for two reasons. First, a progressive tax is considered more equitable (because the wealthy have more ability to pay). Second, extremes of wealth and poverty are considered injurious to the economic and social well-being of a society, and a progressive tax structure tends to moderate such extremes.
On the other hand, tax rates that are too progressive—that rise too steeply—may discourage both work and investment by removing much of the reward. In the early 1980s concern about this problem attracted the attention of policymakers to so-called supply-side economics—to economic theories emphasizing the importance of ensuring that taxes do not drain away incentives to investment, either by individuals or by businesses.