Taxes are generally perceived as a burden by most ordinary citizens and legislators however it is through taxation that the government can raise revenue to fund provision of many public goods and services and distributing wealth. “Taxes are what we pay for a civilised society”, wrote Oliver Wendell Holmes. Broadly, the purposes of taxation are vast including funding for physical infrastructure such as rail and other transport systems, funding for social protection i.e. unemployment & disability protection. Tax is thus justified by the benefits it offers to society. If such benefits are not provided to society, the reason for collecting taxes is lost. There are 3 main bases of taxation: income, capital, and expenditure. With a focus on personal income tax, the purpose of this essay is to explore the challenges that may arise in designing an effective personal income system. While most countries, (particularly developing countries) rely on all the 3 bases, developed countries tend to shift focus mainly on income tax in generating revenue.
How do we identify a good tax system? A good and effective tax system should be designed for equity, efficiency, convenience, and certainty according to Adam Smith’s ‘Canons of Taxation’. Smith outlines his 4 main principles that establish a proper tax system (ifs.org.uk):
- The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities
- The tax which the individual is bound to pay ought to be certain and not arbitrary ...
- Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it.
- Every tax ought to be so contrived as to take out and keep out of the pockets as little as possible, over and above that which it brings into the public treasury of the state.
Additionally, when designing a good income tax system there are other factors that also need to be considered such as tax structure, tax rates, tax burdens, taxpayers’ behaviour, and economic welfare. Most developed countries rely on income taxes as their main source of revenue, so it is crucial to consider such factors. When designing a tax system, policy makers need to take into consideration how taxes affect the distribution of income and how the tax burden will be shared between tax individuals with different incomes. This helps to establish if a tax will be proportional, progressive, or regressive. A proportional structure is one where individuals pay the same tax rate on their income regardless of what they earn. A progressive structure is where those with low incomes pay a lower tax rate than high-income earners. This structure is typical of income tax. A progressive structure is thus seen as one that reduces inequality in income distribution. With a regressive structure, low-income earners pay a higher percentage of taxes than higher income earners. Every country has its own way of manging their tax systems and there are many aspects to look at when reviewing what an effective income system needs; having to examine what is fair and what is feasible, and this can be challenging for policy makers.
Understanding the importance of fairness
Before we delve into the challenges faced when designing a good personal income tax system, it is vital that we understand the importance of fairness in tax. One of the principles Adam Smith points out is that ‘the subject of every state ought to contribute towards the support of the government, as nearly as positive in proportion to their respective abilities…”. He stresses that proportionality should exist with taxes in line with the level and sources of income. Chrestensen (1994) carried out a research titled “The impact of education on the perception of tax fairness” and identified different dimensions of tax fairness: fairness of the tax system, fairness of personal payment level, exchange with the government, tax rate structure, and fairness of special provisions. (Journal of economic sciences)
The importance of fairness rests in how just the system is. Tax burdens should fall on individuals fairly considering their socioeconomic status and their ability to pay. Ability-to-pay principle requires that taxpayers be taxed according to their scope to bear the tax burden. A necessary condition when it comes to equity in tax, is an equal treatment of taxpayers with equal circumstances. This is known as horizontal equity where those with similar income pay the same amount of taxes. This ensures no discrimination considering race, gender etc. In contrast, vertical equity requires tax burdens vary in proportion to income. This implies that those with higher incomes should pay more taxes since people differ in a way that some individuals have different circumstances. It is often accented that the “wealthy” should not have to suffer tax burdens since they have earned their money, but a good tax system should appreciate every worker.
It is also important to understand fairness from taxpayers’ point of view which tends to be shaped by what the government is doing right for them. Is the government providing essential services to their citizens? If so, are the citizens satisfied with how their taxes are utilised? Kirchler (1997) conducted a study on how Australian taxpayers argued that government needs to focus their public spending more on education and health, as well as research and preserving their culture. Similarly, Brazilians have argued for implementation of policies to focus tax spending more on health education and poverty. Andrews (2003) expressed how governments should view society as customers and establish trust and a satisfactory relationship with their “customers”.
Complexity and costs
What makes personal income tax complex? Despite many calls for simplification, the income tax system remains to be significantly complex. Much of its complexity exists from a legal basis though issues may arise in several forms. Prebble (1994) points out that tax legislation is more complex than it needs to be (James and Nobes 2015/16) and that this is due to trying to fit the law around the “natural facts of economic life” thus resulting in the law itself being complex. Complex laws might affect tax individuals’ willingness to comply with the tax system, especially with a system of self-assessment. An overly complex system may also make it difficult for government to estimate future revenues and costs thus implementing economic strategies will be more difficult to do.
There are also complications when defining ‘income’ and deciding the chargeable income and defining capital gains, business income etc. Defining a tax base is just as important as determining what tax rates to implement. When trying to decide what constitutes as income and what to tax, legislation must look at: what is income, whose income it is, the kind of income & when is it income. (William Vickrey, ‘Tax Simplification Through Cumulative Averaging), which leads to reviews over what defines Income, Capital gains etc. More importantly, as a result of its complexity, the tax system incurs great costs that arise from many reasons including trying to simplify the system e.g. costs that are incurred due to trying to make the tax base display tax individuals’ ability to pay. Administrative costs are costs to the government incurred throughout the process of collecting taxes. These include data collection costs, record collecting costs, liaising with tax authorities, filing returns, and dealing with enquiries. Compliance costs, or the “hidden costs of taxation”, are costs incurred mainly by taxpayers’ due to their behaviour. A taxpayer may choose to pay or reduce their tax liability. This is the distinction between tax avoidance and evasion. Tax avoidance is legal manipulation to reduce amount of tax to pay whereas evasion is the illegal practice of avoiding paying tax. Both constitute as non-compliance and can have great implications on the government. If it is realized that tax individuals benefit from such non-compliance it may reduce ‘tax morale’ collectively and in turn reduce compliance which means more costs incurred through more enforcement activities. For a tax system to be effective, it is vital that most tax individuals comply however there are many reasons why taxpayers may fail to comply, and the government need to question how best to tackle this. Government needs to realize that enforcement activities such as fines, number of tax rates is not the sole strategy to improve compliance and could possibly increase tax complexity instead.
Influence of inflation
The effect of inflation on the income tax system has not received much attention since the worldwide decline of inflation rates in the 1980s. In an income tax system, inflation can distort tax base and the tax structure. With a progressive tax structure, high income earners are subject to higher tax rates and with inflation, they are again subjected to increasing tax rates. To compensate for inflation, this means more adjustments by tax authorities and self-assessments. High inflation rates leads to tax authorities increasing tax rates by increasing the prices on goods and services which will affect household income and spending. Mahdavi (2008), reported findings on how inflation is one of the major factors that influences a country’s tax policies. Understanding how such a determining factor can affect some elements of tax revenue is important for tax authorities in designing an effective tax system that will not significantly affect taxpayers’ savings and choices. Qadir Patoli et al. (2012) conducted a study on the impact of inflation on taxation in Pakistan and established that inflation has a positive correlation with taxation. Changes in inflation rates could affect tax rates and consequently affect tax morale resulting to evasion or avoidance. Increase in tax rates caused by inflation when rules are not adjusted will largely affect low-income earners more than high-income earners which again raises a question of equity when designing an income tax system.
Most countries face significant fiscal challenges. A good and effective income tax system should not only be about yielding revenue but should also incorporate a fair tax environment by considering the ability to pay and encouraging low compliance costs. The notion of fairness though not simple to define, in respect of law should be about locating the tax burden enough to leave taxpayers with enough income for their day-to-day activities. In designing an income tax system, for many developing countries, the focus is how they can increase revenue rather than a question of “if they should”. The only possible way to increase revenue is to increase tax rates and improve their tax administration but this is easier said than done. Increasing tax rates could increase inequity since those who cannot bear the burden may choose to flee from it. Imposing taxes has great economic costs well past the costs of revenue collection. Taxation also has effects on behaviour which consequently will affect people’s decisions about their work pattern, how much savings they acquire and how much they can consume, and this can thus be a disincentive to work effort. Additionally, compliance costs of tax as well as public administration costs must be considered. In designing a personal tax system, the government will hence face such challenges and therefore need to find some balance between how they raise revenue, equity, efficiency and lowering the economic costs of taxation, which can be difficult.