Optimal Taxation in Theory and Practice - Case Study Example

Taxation Name Institution Course Date Taxation The world’s economy has dramatically grown over the years (Budd, 2004). One key reason for the rapid growth of economy is the fact that governments and business people have put their efforts on economy efficiency more than equity. Even though economic efficiency has undergone improvement, a good number of social issues related to equity have occurred. For example, income gap existing between rich states and poor states which can result to unbalance of global economy and politics has increased over the years (Wilkinson and Pickett, 2010). The important principles of economics is based on the fact that society faces trade-offs; a common trade-off existing is between efficiency and equity goals (Mankiw, 2012). This means that, it is very difficult to achieve efficiency and equity goals simultaneously. The manner in which taxes are raised and the purpose it is put result to trade-off between equity and efficiency. This essay will define efficiency and equity and then analyse and evaluate how it is very difficult to achieve equity and efficiency goals on the bases of taxation. Taxation can be defined as a system that a particular government utilizes to collect taxes from business organisation and individuals with relation to their income, earnings, transaction and asset values (Cch, 2008). Fundamentally, taxation is used to raise revenue that does not promote beneficial activities for the government including starting a business that limit undesirable behaviour or promote education etc. Taxpayers most often than not hesitate to take time and effort to conform to the tax code or pay taxes. In order to palliate the impacts of taxation on individuals, tax policy often strives to achieve the objective of efficiency and equity. Tax efficiency reduces the cost of conforming to the tax code through minimizing its administrative burden and any distortions in the economy influenced by the tax. Minimizing the administrative burden benefits both the taxpayers and the economy as tax collection is just a requirement and not an objective of tax policy (Cch, 2008). On the other hand, taxation equity is termed as the principle that entails fairness of tax (Parkin, Powell and Matthews, 2005). There are many criteria that ascertain what is fair. For instance, the benefit principle entails people paying taxes on the basis of the benefits they receive from government services. The ability-to-pay principle can be either vertical equity or horizontal equity. Horizontal equity principle states that people with high expenses should pay small tax compared to people receiving equal income but with low expenses (Wilkinson and Pickett, 2010). On the other hand, vertical equity principle states that people with high incomes should pay more taxes than people receiving low income. It is well known that today’s society is faced with trade-off between efficiency and equity (Parkin, Powell and Matthews, 2005). For instance, individual income tax can lead to decrease of productive motivation. For this, such policy reduces efficiency. On the other hand, pursuit for efficiency tends to impair equity. Government often manipulate their spending and income in order to attain the set economic and social objectives. In doing so, they set a balance between period of inflation and period of recession. During high inflation, the government may rise taxes and reduce expenditure and during period of recession, the government reduces taxes and increase expenditure (Cch, 2008). Therefore, justifiable taxation system is very strict in incorporating the fiscal policy for the reason of balancing payment, employment level and distribution of wealth and income. The concept of equity entails the contribution of the taxpayers towards government activities on the basis of the ability to pay. This concept is aimed at ensuring fairness and equitability in taxation (Parkin, Powell and Matthews, 2005). Upholding equity concept of taxation, people are motivated to contribute towards public operations in a way they perceive satisfactory to them. Despite the logics of the equity concept, it suffers the disadvantage in relation to efficiency. Inefficiency is based on the fact that there would be a decrease in the quantity of goods or services demanded if the direct beneficiaries contribute amount equal to the derived value. Also, implementation of the equity concept of taxation faces negative challenges on public goods. Not including the non-payers and establishing the received benefits becomes complicated making it difficult to identify amount of tax (Cch, 2008). In addition, services provided including national security and infrastructure may be beneficial to every individual but not in equal proportions. Equity concept establishes that the basis of taxation should be founded on the ability to pay. This supports that the people who earn more should contribute more tax. This concept however brings challenges for the efficiency concept because public goods are not charged to individuals and taxation is not attached to the beneficiaries alone. Equity principle focuses on two scenario; individuals having equal ability paying identical taxes and individuals having different abilities contributing different taxes. Both vertical and horizontal equity scenario supports the fact that taxes should be fairly paid by involved parties. Horizontal equity taxation is considered direct and simple and shields taxpayers from discrimination (Wilkinson and Pickett, 2010). However, horizontal equity may be disadvantaged for external cost. For instance, products such as tobacco yield high taxes to the smokers regardless of having same income as non-smokers. On the other hand, vertical equity is based on the proportionality in tax payment since all the factors that result to variation in income are considered. In any region at any particular point, resources would be comparatively scarce. It is impossible to get what we want. It is thus important to decide the priorities before distributing the resources. Situations like this calls for consideration of efficiency and equity. When the distribution of resources in a particular economy is fair in the society, then this indicates equity (Budd, 2004). Also, efficiency can be termed as utilizing scares resources at appropriate price. Generally, efficiency is the scope of economic resource and equity is how such economic resource is distributed. This is to mean that when the economic resources are distributed, there result to a trade-off between equity and equity. Such a trade-off is a fundamental principle in economics (Parkin, Powell and Matthews, 2005). Taxation is the key strategy that the governments raise revenues used to finance public expenditure. The main disadvantage of taxes in relation to efficiency perspective is the fact that taxes minimizes the incentives for individuals to create deadweight loss. Income tax is partially the transfer of value from employers or employees to the government, or can be termed as deadweight loss. This deadweight loss results every time incentives to work are affected. For this, it is not surprising that most efficient and effective tax is the one that has no effect on the incentives to work (Cch, 2008). An example of efficient taxes is the lump-sum tax. For instance, suppose that a lump-sum tax of $400 is put in place then, every person would be required to pay this amount regardless of the money one makes or uses. Thus, such tax does not cause any distortion to the incentives for work. Therefore, the lump-sum tax is very efficient and effective in maximizing the size of the economic pie since there lacks black hole of deadweight loss. However, paying the same amount of tax is considered unfair for the poor people (Cch, 2008). For this, a society sacrifices in terms of efficiency to gain in equity. Therefore, there is no clear answer in equity verses efficiency goal. As seen earlier, the governments use taxation in some circumstances for the main purpose different from raising capital needed to take care of its expenditures. Economic resources are considered limited and scarce, thereby a raise in government spending often than not result to decrease in private expenditure. To add to this, taxation is a strategy used to transfer resources from private setting to the public sector (Cch, 2008). However, use of taxation to transfer resources leads to inflation. The government can use an alternative approach of raising money through charging the goods and services it offers. Nevertheless, it is impossible to charge people based on their utilization of government services. Economic function that the government is entitled to do can be divided into three categories. To start with, the government is expected to overcome the ineffectiveness of the market ability to allocate economic resources. Second, it is entitled to reorganise income and wealth in equitable manner. Third, the government is expected to smooth out cyclical fluctuations by ensuring high rate of employment and price stability. Another important function of the government is to use taxes in improving market work. Tax system of distribution and the purpose to which it is used can be analysed whether effective or not by considering four criteria namely efficiency, equity, incentives and macroeconomics (Boortz and Linder, 2006) . On the basis of equity, there is no clear definition of what is fair and what is not fair (Boortz and Linder, 2006). In order to determine what tax system is fair, fairness can be achieved by ensuring every person is entitled to their fair of taxation and contribute correct amount. According to economists, fairness in taxation should be contrived as taking out or keeping off the pockets of individuals as much as possible. However, the more equitable taxes are, the less efficient they are to collect. The efficiency of any particular system requires additional improvements to reduce tax evasion. Although the most important purpose of taxation is to generate revenue for the government to be able to meet public expenditures, taxation can be a system of regulating social and economic behaviour through distribution of economic resources (Dodson and Wodon, 2008). Typically, in the society we live in, there are people who are paid better salaries compared to others who are paid lower salaries. In such situation, rich individuals becoming richer or poor people becoming poorer can result with economic power concentrating in few hands. Due to this, some electors suggest that these trends can be countered by taxation systems which redistribute wealth or income towards the poor. Economy alone is not enough to balance equity and efficiency goals (Budd, 2004). Social and political factors attribute to such balance. For instance, if we consider the Tax System for India, the country had a progressive taxation system after independent where rich individuals paid higher amounts of taxes that the poor people depending on the amount of their income. However, after liberalisation, Indian economic and political agenda highly differed in regard to equity and efficiency. It was observed that high tax rates minimized economic efficiency and incentive to work, for this reason, tax reforms took place. Today, tree slabs are available for income tax. Even the richest individual earning more salaries would pay not above 30% of the income as tax. In such a situation, there is constant trade-off existing between efficiency and equity (Brandon, 2012). In general, economic efficiency and social equity tend to conflict with each other since what is considered socially equitable may not enhance the allocation of resources (Brandon, 2012). Thus, there is an existing trade-off between equity and efficiency. The benefits of greater equity include effective allocation of tax code and resources, and low-income earners are motivated to work harder in an event of fair distribution of resources. However greater equity reduces incentives to work and willingness to produce and the link between efforts and reword is minimized. Market strives for efficiency and often reward producers in accordance with value in production. On the other hand, government strive for greater equity based on greater distribution. Efficiency and equality decisions should be guided by informed environment in order for it to work for the wellbeing of the society (Mankiw and Weinzierl, 2010). In conclusion, the term efficiency can be described as the property of the society getting the most they can and equity is fairness that result in allocating the economic resources among the social members. Due to the trade-off existing between efficiency and equity goals in terms of the purpose to which taxes are allocated and distributed, it is very important to determine which one is more important. Sometimes efficiency can be considered more essential than equity in relation to different social groups and economic styles and in other situation efficiency can be compromised for equity. However, decisions regarding trade-offs between efficiency and equity in terms of taxation would be guided by informed environment in order for it to work for the wellbeing of the society (Parkin, Powell and Matthews, 2005). References Brendon, C.F. (2012), .Efficiency-equity Trade-offs for Dynamic Mirrleesian Tax Problems., Manuscript (available at http://mwpweb.eu/CharlesBrendon) Boortz, N. & Linder, J. (2006). The FairTax book : saying goodbye to the income tax and the IRS : not to mention the Social Security tax, the Medicare tax, corporate income taxes, the death tax, the self-employment tax, the alternative minimum tax, the gift tax, capital gains taxes, tax audits, and some major headaches every April 15. New York: Regan Books. Budd, J. (2004). Employment with a human face : balancing efficiency, equity, and voice. Ithaca, N.Y. London: ILR Press. Cch. (2008). Internal Revenue Code 2008 Income, Estate, Gift, Employment and Excise Taxes (Summer 2008 Edition. City: Cch Inc. Dodson, B. & Wodon, Q. (2008). Public finance for poverty reduction concepts and case studies from Africa and Latin America. Washington DC: World Bank. Mankiw N.G. (2012),"Principles of Economics", 6th Edition. Mankiw, N.G., M.C. Weinzierl and D. Yagan (2009), .Optimal Taxation in Theory and Practice., Journal of Economic Perspectives, 23, 147.174. Parkin, M.,Powell, M.& Matthews, K. (2005) Economics. Spain: Pearson Education Limited Wilkinson, R. & Pickett, K. (2010). The spirit level why greater equality makes societies stronger. New York: Bloomsbury Press Read More