Whether Exists Perfect Tax System - Essay Example

Public Finance Table of Contents Introduction 3 Features of a tax system 4 Features of Optimal tax system 6 Factors influencing optimality of tax system 6 Designing optimal set of taxes 7 Optimality of Tax system 9 Conclusion 12 References 14 Introduction Tax system refers to the collection of taxes by the government. Government is the regulatory authority that monitors the tax system. It is responsible for developing a framework for collection of taxes. It is a revenue stream for the government. It uses the tax revenue for economic welfare programmes. Thus, an effective tax system should ensure timely collection of tax so that it can support the various developmental programmes of the government. In effective tax system will compel the government with fund shortage that will lead to government borrowing. High government borrowing will create high level of debt. Effective tax system aims at complementing government’s budget plans. Any shortfall in tax collection will lead to budget deficit that will lead to fiscal deficit. High government debt is detrimental for economic prospects of a country. It signifies weak federal structure which will affect foreign investment. Foreign investors look out for stable economies to invest their money which will yield higher returns. Governments of different nations aim at promoting its export sector to boost its foreign exchange earnings. Thus, an effective tax system would look to compensate for the high subsidy bill that is given for promoting underdeveloped and export oriented sectors. Tax system across the world are categorised in three ways i.e. regressive, proportional and progressive. In general taxes are levied on individuals and businesses. Government usually impose a certain percentage or slabs to determine the taxability of individuals and companies. There is another classification for taxes which is based on the impact and incident of taxation. It is direct and indirect. Direct taxes imply where the impact and incident is on the same individual and which cannot be shifted. Income tax, corporation tax are examples of direct taxes. Whereas consumption tax, excise duty, customs are indirect taxes. Such taxes have different points of impact and incident i.e. the burden of the tax can be shifted from the producers to consumers. In certain countries an amount is deducted from the income of individuals towards insurance contributions like NIC in UK (James, 2009). Features of a tax system There are certain features that are attributed to the tax system to ensure equity at all levels. Governments across the world usually follow either of the three tax systems i.e. regressive, proportional and progressive. Fiscal authorities design the tax structure in a way that ensures a balance between savings and expenditure. It is a major trade off for the authorities as focussing on one would cost the other. If a government focuses on savings then the level of expenditure will fall this will lead to fall in growth level. On the contrary if expenditure rises there will little left with the individuals to pay their taxes. Thus regulatory authorities should strike a mixture of the proportional, progressive and regressive taxing mechanisms to promote economic growth as well as stimulate savings that will lead to investments. Tax system basically has four features which are equity, adequacy, transparency and administrative. Equity is classified in two ways horizontal and vertical equity. Horizontal equity ensures that individuals with identical financial condition should pay equal taxes. In other words it refers to the equal treatment under similar situation. On the contrary vertical equity refers to the transfer of wealth from the rich to the poor where individuals earning more end up paying more taxes than those who earn less. It is also known as the percolation effect where higher tax revenue generated from the rich are transferred to the poor in way of welfare programmes like health, education, social security, etc. Vertical equity is further classified into three more categories i.e. regressive, proportional and progressive. Regressive tax refers to where lower income earning individuals pay higher share of taxes compared to higher income group. In other words with increasing level of income individuals pay lower taxes. Governments use regressive tax on necessity goods as it would lead to higher collection of taxes owing to large spending by individuals. Proportional taxes refer to equal tax rates compared to the level of income. In other words the tax increases in equal proportion with the increase in income. Progressive tax requires higher income earning individuals to pay higher taxes compared to lower earning individuals. Governments use progressive tax in the aim to distribute wealth in the society. It is believed that individuals who earn more should be taxed more than individuals who earn less. Income tax is one example of progressive tax (Lymer and Hasseldine, 2002). Adequacy as a feature of tax system ensures that the government receives sufficient tax revenue to support its developmental programmes. Government has to ensure amenities like health, infrastructure, education, etc to meet the demand of public services. Tax system should ensure transparency. Transparency refers to the sharing information with the tax payers. Information includes how the money is utilised for public services. It also refers to transparency in sharing information about tax benefits like exemptions, deductions and credit. Moreover transparency will stimulate individuals to pay taxes than evade it. Tax system should ensure low cost for the tax payers and the collectors. For collectors the cost of collection should be low. Tax system should be framed in such a manner that will result in timely collection of taxes and effective audit practices. Tax system should have simple rules, uncomplicated process so that individuals can easily comply with the payment process. It should be flexible so that any changes will result in quick implementation. With rapidly changing economic conditions a change in tax system should not affect the overall structure. Thus, there should be dynamism or stability in the system that will effectively respond to the externalities. The tax system has certain perks which are exploited by individuals and businesses. There are various tax benefit schemes like deductions, grants, exemptions and credits that are given to individual and companies. Such tax benefits are sought by individuals and businesses to reduce the tax liability. Often at times such entities conceal the sources of income to evade the effects of taxation. Businesses and individuals make charitable contributions to fictitious institutions to leverage lower taxability. Businesses exploit such avenues to launder illegal money and thus avoid paying taxes. Fiscal authorities should thus frame a tax system that will effectively monitor and control illegal practices and impose penalty for making such defaults that directly impacts economic prosperity. Tax exemptions and credits should be provided in order to stimulate investments and not just to avoid higher taxability (Viard and Carroll, 2012). Features of Optimal tax system Factors influencing optimality of tax system There is no perfect tax structure that will balance the growth and stabilization policies of fiscal authorities. Moreover tax system can try to achieve a balance or optimality by adopting various features of the tax system. Economies are rapidly changing with global integration. This has led to rise in the volume of trade and income for corporate and individuals. The rise is witnessed more in case of businesses than individuals. Demand for foreign products have led to standardization of currency i.e. dollar as a standard currency for trade between nations. This influences the demand for foreign exchange. Different nations have different economic, demographic, political, technological and environment factors that determines the tax system. A tax system that has achieved optimality may not work well in US or emerging economies. The state of the economy is another critical determinant for implementing an effective tax structure. Demographic factors also affect the optimality of taxes. Countries like US, Japan etc have high ageing population that will affect the savings and investment pattern. Thus such implications need to be considered for setting optimal taxes. Emerging economies have high young population and will experience different tax optimality. Unequal income distribution in an economy is also another factor that impacts the tax system and thus becomes imperative for fiscal authorities to set optimal taxes. The price elasticity of demand and supply in an economy will also influence the optimality. For instance goods with high price elasticity will be taxed at lower rates and goods with low price elasticity it will be taxed at higher rates. The logic behind this is that taxes increase the price of commodity and goods which are highly elastic i.e. a slight change in price will offset the quantity demanded by a good margin. Increased prices of commodities will be followed by low demand that will drive away the economic growth (Kaplow, 2011). Designing optimal set of taxes The theory of optimality ensures maximum utility to the society with the given level of constraints. It aims to maximise the economic welfare under a given set of constraints as discussed in the earlier section. Optimal tax structure can be achieved by striking parity between the rich and the poor. Though there cannot be one optimal tax rate for a country, but government can always adjust its tax system to achieve optimality whereby individuals at the bottom of the pyramid will be benefited. In most economies the middle and lower income group comprise the largest share. Fiscal authorities should ensure that low income earning individuals should not be taxed at higher rate. It should also consider the impact of higher taxation on producers. High excise and customs duty will lead to increased cost of inputs for production that will result in cost push inflation. Tax system facilitates government’s growth and stabilization policies i.e. GDP and inflation (Phelps, 2014). An effective and transparent tax structure should be set that would result in optimality. A transparent system will lead to increased confidence and trust of the tax payers towards the government. It should provide relevant information to individuals to motivate them towards paying taxes. Regular data should be published that will contain information about how the tax money is utilised for public welfare activities. How much of direct and indirect tax was collected and how much is spent. Information relating to tax exemptions and credit should also be provided. The system of payment and collection should be simplified so that it results in reduced cost for both the tax payer and the collector. The tax structure should be less complicated as this would ensure better understanding of the rules that would result in reduced avoidance and increased participation. Optimality does not only signify the use of quantitative measures but also includes the qualitative factors that would result in increased revenue for the government to meet the demands of public services. It should ensure horizontal and vertical equity. In other words it should set similar tax rates for individuals having identical financial status and income. It can ensure vertical equity by taxing the rich at a higher rate so as to redistribute the wealth from the rich to the poor. This is also described as the progressive tax system where with high income levels the tax rate also increases and vice versa. A progressive tax cannot only be sustained as it has to be followed by regressive system which will stimulate the buying. Thus, regulatory authority should impose regressive taxes on necessity goods which will increment its revenue by a larger base. Optimality is best achieved when there are sufficient benefits to either party i.e. tax collectors and tax payers. Tax collectors cannot ensure high tax revenue with low tax rates. Fiscal authorities cannot totally follow one type of taxes to achieve optimality rather it should have both direct and indirect taxes which will boost its revenue. Government cannot only have direct taxes or indirect taxes to achieve optimality. If it were to remove income taxes and only have consumption taxes this would result in increased disposability but owing to flatter rates will result in lower revenue generation. Thus there is a need for both types of taxes in order to achieve optimality (Tresch, 2014). Optimality of Tax system The optimality of tax system can be defined as the system that is designed and implemented for reducing the distortion or the inefficiency that exist in the tax structure under various economic condition and constraints. It mainly includes the features such as the collection of tax, compliance of tax, tax enforcement and also allocation of the revenues to various departments. Optimality is required to consider all the features related to the equality in income, convenience of the payment, maintaining certainty and the economy in collection. The practical approach of the tax policy deals with the combination of both the analysis of the tax reforms and the theory related to optimal tax. The optimal taxation is a concept in which the individuals are differentiated on the basis of their marginal utility in income and the lump sum amount is transferred between the individuals for maximizing their overall welfare. This can be explained with the help of the following equation U1 = u1 (a1 (Yoi + Wi Li + Ti)) - Li Where, Yoi represents the income that is generated from wealth Li The amount of labour that is supplied Wi The rate of wage of the individuals. The policy makers are very selective in adopting and implementing the optimal tax structure. The rate of marginal tax has decreased significantly and the undifferentiated taxes charged on the capital income have been accomplished successfully. The main issues or the problem that is associated with the optimal tax system is that it is irrelevant to design the tax structure or system practically. The main constraint of this system is that it ignores the consideration that is related to societal and fiscal elements required for the analysis of the taxation. The optimal tax system is unable to increase the social welfare without the reduction of the overall tax revenue. The optimal tax theory is not complete for providing guidance or instruction for dealing with the critical or the complex issues that are related with the taxation policy. The main reason behind the incompletion of the optimal tax system is that it is unable to collect the taxes from those individuals who resist in paying of taxes. The theory does not deal with the political process and it does not consider the aims and the objective of the policy makers that is not related to maximization of the social welfare (Carlos and Krueger, 2006). The optimal tax system is not only considered as an important aspect of the tax system that is interesting for the policy makers, but there are also other aspects that are considered as important for the taxpayers. The other aspects that are interesting for the policy makers are deciding on the various aspects that are considered as a matter of interest for the public and deciding on the various ways or means of spending funds for the public works. The optimality aspect in the tax system considers the efficiency cost. But it is required to consider the effect of the distribution on the common welfare of the people. Therefore there are various aspects that are considered by the policy makers apart from the aspect of optimality in the tax structure. The optimality in the tax system encounters various problems or issues related to interpersonal comparisons of providing common welfare since it ignores the representative customer in its assumptions and therefore the concept of optimality becomes more complex and critical. The optimality condition that exists in the tax system is required to be modified through the process of redistribution of the welfare by the implementation of the fiscal system. The optimality in relation to the regressive taxation doesn’t consider the change in the welfare where the capital holdings are considered to be larger. The accumulation of the additional capital is required to be considered for the consumption of leisure and the goods (Carroll, Frijters and Shields, 2009). The optimality in the tax system is subjected to certain constraint in which the purpose of the optimal taxation is transferring and redistributing the income from those who earns low marginal utility of income to higher marginal utility of income The optimality in case of designing the tax system or the tax structure is subjected to constraint and problems. Therefore redistributed tax structure is required to be implemented. The redistribution of the taxation policy will facilitate in the accumulation of capital resulting in the decrease in investment. The policy makers also concentrates on the aspect of regressive tax structure since it results in higher consumption and higher output at the cost of increase in inequality that exist after the tax income. The differential rate of tax is required to be taken into consideration while determining the optimality in the taxation system. When the uniform sales tax is optimal then the proportion or the amount of revenue that is increased by the sales tax and also by the income at is required to be taken into consideration. Optimal tax system mainly focuses on the commodity taxes and the personal income taxes which includes the tax that is levied for the international trade. But the optimal tax system does not deal with the taxation of the company, inheritance taxes and the tax on the capital gains. Therefore there are other aspects that are considered by the policy makers apart from considering the optimality in the tax system or the tax structure (Albanesi and Sleet, 2006). The theory of optimal policy is responsible for dealing with various fundamental issues related to the tax policy in an effective way. The optimal tax system depends not only on the price elasticity of the demand but it also depends on the income elasticity in which it determines the change in the budget with the rise in the income. The policy maker prefers the tax system that is less progressive in nature. The policy maker concentrates on the intergenerational tax that is related to the increase in welfare and the issue related to debts will be solved against the income that will be generated in the future. Conclusion There is no perfect tax system. With the advent of global integration of trade and business the tax system should be flexible enough to accommodate the change so as to create a balance between the tax collectors revenue and the tax payers cost. Conducive tax system will attract foreign capital that will economically benefit a country. Foreign capital will help the local industries with the much needed funds that will help them grow. This would result in inclusive growth where domestic expansion of the industries will result in increased employment which would further increase the earning of the government from increased earnings through taxes. Fiscal authorities can either have high tax rates, low tax rates or optimal tax rates. High tax rates would be detrimental for the growth of the economy. This will lead to reduced tax payer’s base as they would use more tax benefits and credits to avoid paying higher taxes. This will ultimately result in low tax revenue for the government. High tax rate will also discourage foreign direct investment. On the contrary low tax rate will result in satisfied tax payers but will also generate low levels of tax revenue. Thus fiscal authorities need to manage the trade off between high and low tax structures. This would eventually lead to achieving optimality of taxes which would meet the economic welfare at a low cost for the tax payers and tax collectors (Bhatia, 2009). References Albanesi, S. and Sleet, C., 2006.Dynamic Optimal Taxation with Dynamic Optimal Taxation with Private Information. Review of Economic Studies, 73 (1), pp. 1–30. Bhatia, L. H., 2009. Public Finance. Delhi: Vikas Publishing House Pvt Ltd. Carlos, C.J. and Krueger, D., 2006.On the optimal progressivity of the income tax code. Journal of Monetary Economics, 53 (7), pp. 1425–1450. Carroll, N., Frijters, P. and Shields, MA., 2009. Quantifying the costs of drought: New evidence from life satisfaction data. Journal of Population Economics, 22(1). pp. 445- 461. James, M., 2009. The UK Tax System: An Introduction. London: Spiramus Press Ltd. Kaplow, L., 2011. The Theory of Taxation and Public Economics. USA: Princeton University Press. Lymer, A. and Hasseldine, J., 2002. The International Taxation System. USA: Springer Science & Business Media. Phelps, S. E., 2014. Studies in Macroeconomic Theory: Redistribution and Growth, Volume 2. London: Academic Press. Tresch, W. R., 2014. Public Finance: A Normative Theory. UK: Academic Press. Viard, D. A. and Carroll, R., 2012. Progressive Consumption Taxation: The X-Tax Revisited. USA: AEI Press. Read More