Taxation, classes of Taxes,, History of Taxation
Taxation is imposition of compulsory levies on individuals or entities by governments. Nearly every nation in the world imposes taxes, primarily to raise funds for government expenditures but also for other purposes. Purposes of taxation.
In the 19th century, most people thought that taxes should mostly be used to pay for the government. In earlier times, and again today, governments have utilized taxation for other than merely fiscal purposes. One useful way to view the purpose of taxation, attributable to American economist, is to distinguish between objectives of resource allocation, income redistribution, and economic stability. (Economic growth or development and international competitiveness are sometimes referred to as distinct objectives, but they typically fall under the umbrella of the other three.) In the absence of a strong reason for interference, such as the need to reduce pollution, the first objective, resource allocation, is furthered if tax policy does not interfere with market-determined allocations. The second objective, income redistribution, is meant to lessen inequalities in the distribution of income and wealth. Maintaining high employment and price stability are the goals of stabilization, which is carried out through tax policy, government expenditure policy, monetary policy, and debt management. There are likely to be conflicts among these three objectives. For example, resource allocation might require changes in the level or composition (or both) of taxes, but those changes might bear heavily on low-income families—thus upsetting redistributive goals. As another example, taxes that are highly redistributive may conflict with the efficient allocation of resources required to achieve the goal of economic neutrality.
Classes of taxes
Direct and indirect taxes
In the literature of public finance, taxes have been classified in various ways according to who pays for them, who bears the ultimate burden of them, the extent to which the burden can be shifted, and various other criteria. Taxes are most commonly classified as either direct or indirect, an example of the former type being the income tax and of the latter the sales tax. There is much disagreement among economists as to the criteria for distinguishing between direct and indirect taxes, and it is unclear into which category certain taxes, such as corporate income tax or property tax, should fall. It is usually said that a direct tax is one that cannot be shifted by the taxpayer to someone else, whereas an indirect tax can be.
Direct taxation Direct taxes are primarily taxes on natural persons (e.g., individuals), and they are typically based on the taxpayer’s ability to pay as measured by income, consumption, or net wealth. What follows is a description of the main types of direct taxes.
Individual income taxes are commonly levied on total personal net income of the taxpayer (which may be an individual, a couple, or a family) in excess of some stipulated minimum. They are also commonly adjusted to take into account the circumstances influencing the ability to pay, such as family status, number and age of children, and financial burdens resulting from illness. The taxes are often levied at graduated rates, meaning that the rates rise as income rises. Personal exemptions for the taxpayer and family can create a range of income that is subject to a tax rate of zero.
A person's total net worth, or the value of his assets minus his liabilities, is the basis for taxes on net worth. As with the income tax, the personal circumstances of the taxpayer can be taken into consideration.
Personal or direct taxes on consumption (also known as expenditure taxes or spending taxes) are essentially levied on all income that is not channeled into savings. In contrast to indirect taxes on spending, such as the sales tax, a direct consumption tax can be adjusted to an individual’s ability to pay by allowing for marital status, age, number of dependents, and so on. Although long attractive to theorists, this form of tax has been used in only two countries, India and Sri Lanka; both instances were brief and unsuccessful. Near the end of the 20th century, the “flat tax”—which achieves economic effects similar to those of the direct consumption tax by exempting most income from capital—came to be viewed favorably by tax experts. No country has adopted a tax with the base of the flat tax, although many have income taxes with only one rate.
Taxes at death take two forms: the inheritance tax, where the taxable object is the bequest received by the person inheriting, and the estate tax, where the object is the total estate left by the deceased. Inheritance taxes sometimes take into account the personal circumstances of the taxpayer, such as the taxpayer’s relationship to the donor and his net worth before receiving the bequest. Estate taxes, however, are generally graduated according to the size of the estate, and in some countries, they provide tax-exempt transfers to the spouse and make an allowance for the number of heirs involved. In order to prevent the death duties from being circumvented through an exchange of property prior to death, tax systems may include a tax on gifts above a certain threshold made between living persons. Because large tax payments can be easily avoided through estate planning, taxes on transfers typically do not generate much revenue. Taxes from the side Indirect taxes are levied on the production or consumption of goods and services or on transactions, including imports and exports. Examples include general and selective sales taxes, value-added taxes (VAT), taxes on any aspect of manufacturing or production, taxes on legal transactions, and customs or import duties.
Levy's known as general sales taxes are applied to a sizeable portion of consumer expenditures. The same tax rate can be applied to all taxed items, or different items (such as food or clothing) can be subject to different rates. Single-stage taxes can be collected at the retail level, as the U.S. states do, or they can be collected at a pre-retail (i.e., manufacturing or wholesale) level, as occurs in some developing countries. Multistage taxes are applied at each stage in the production-distribution process. The VAT, which increased in popularity during the second half of the 20th century, is commonly collected by allowing the taxpayer to deduct a credit for tax paid on purchases from liability on sales. The VAT has largely replaced the turnover tax—a tax on each stage of the production and distribution chain, with no relief for tax paid at previous stages. The cumulative effect of the turnover tax, commonly known as tax cascading, distorts economic decisions.
Although they are generally applied to a wide range of products, sales taxes sometimes exempt necessities to reduce the tax burden of low-income households. By comparison, excises are levied only on particular commodities or services. While some countries impose excises and customs duties on almost everything—from necessities such as bread, meat, and salt, to nonessentials such as cigarettes, wine, liquor, coffee, and tea, to luxuries such as jewels and furs—taxes on a limited group of products—alcoholic beverages, tobacco products, and motor fuel—yield the bulk of excise revenues for most countries. In earlier centuries, taxes on consumer durables were applied to luxury commodities such as pianos, saddle horses, carriages, and billiard tables. Today a main luxury tax object is the automobile, largely because registration requirements facilitate administration of the tax. Some countries tax gambling, and state-run lotteries have effects similar to excises, with the government’s “take” being, in effect, a tax on gambling. Some countries impose taxes on raw materials, intermediate goods (e.g., mineral oil, alcohol), and machinery.
Some excises and customs duties are specific—i.e., they are levied on the basis of number, weight, length, volume, or other specific characteristics of the good or service being taxed. Other excises, like sales taxes, are levied on the value of the goods as measured by the price. Taxes on legal transactions are levied on the issue of shares, on the sale (or transfer) of houses and land, and on stock exchange transactions. For administrative reasons, they frequently take the form of stamp duties; that is, the legal or commercial document is stamped to denote payment of the tax. Many tax analysts regard stamp taxes as nuisance taxes; they are most often found in less-developed countries and frequently bog down the transactions to which they are applied.
Proportional, progressive, and regressive taxes
Taxes can be distinguished by the effect they have on the distribution of income and wealth. A proportional tax is one that imposes the same relative burden on all taxpayers—i.e., where tax liability and income grow in equal proportion. A progressive tax is characterized by a more than proportional rise in the tax liability relative to the increase in income, and a regressive tax is characterized by a less than proportional rise in the relative burden. Thus, progressive taxes are seen as reducing inequalities in income distribution, whereas regressive taxes can have the effect of increasing these inequalities.
The taxes that are generally considered progressive include individual income taxes and estate taxes. However, if a taxpayer is allowed to reduce his tax base by declaring deductions or by excluding certain income components from his taxable income, income taxes that are supposed to be progressive may become less so in the upper income brackets. Proportional tax rates that are applied to lower-income categories will also be more progressive if personal exemptions are declared.
Income measured over the course of a given year does not necessarily provide the best measure of taxpaying ability. For instance, temporary increases in income can be saved, and temporary decreases in income can be used to reduce savings to finance consumption by a taxpayer. Thus, if taxation is compared with “permanent income,” it will be less regressive (or more progressive) than if it is compared with annual income.
Sales taxes and excises, with the exception of those that apply to luxuries, typically have a tendency to be regressive because the proportion of personal income spent on a particular good decreases as personal income rises. Poll taxes (also known as head taxes), levied as a fixed amount per capita, obviously are regressive.
Due to uncertainty regarding the capacity of businesses to shift their tax expenses, it is difficult to classify corporate income taxes as progressive, regressive, or proportionate. This difficulty of determining who bears the tax burden depends crucially on whether a national or a subnational (that is, provincial or state) tax is being considered.
In considering the economic effects of taxation, it is important to distinguish between several concepts of tax rates. The statutory rates are those specified in the law; commonly these are marginal rates, but sometimes they are average rates. Marginal income tax rates indicate the fraction of incremental income that is taken by taxation when income rises by one dollar. Thus, if tax liability rises by 45 cents when income rises by one dollar, the marginal tax rate is 45 percent. Income tax statutes commonly contain graduated marginal rates—i.e., rates that rise as income rises. Careful analysis of marginal tax rates must consider provisions other than the formal statutory rate structure. If, for example, a particular tax credit (reduction in tax) falls by 20 cents for each one-dollar rise in income, the marginal rate is 20 percentage points higher than indicated by the statutory rates. The relevant marginal rates for evaluating the incentive effects of taxation are those that show how after-tax income changes in response to changes in before-tax income. It is even more difficult to know the marginal effective tax rate applied to income from business and capital, since it may depend on such considerations as the structure of depreciation allowances, the deductibility of interest, and the provisions for inflation adjustment. Under a consumption-based tax, the marginal effective tax rate on capital income is zero, according to a fundamental economic theorem. Average income tax rates indicate the fraction of total income that is paid in taxation. The pattern of average rates is the one that is relevant for appraising the distributional equity of taxation. Under a progressive income tax, the average income tax rate rises with income. Average income tax rates commonly rise with income, both because personal allowances are provided for the taxpayer and dependents and because marginal tax rates are graduated; on the other hand, preferential treatment of income received predominantly by high-income households may swamp these effects, producing regressively, as indicated by average tax rates that fall as income rises.
History of taxation
Taxation administration Although views on what is appropriate in tax policy influence the choice and structure of tax codes, patterns of taxation throughout history can be explained largely by administrative considerations. For example, because imported products are easier to tax than domestic output, import duties were among the earliest taxes. Similarly, the simple turnover tax (levied on gross sales) long held sway before the invention of the economically superior but administratively more demanding VAT (which allows credit for tax paid on purchases). It is easier to identify, and thus tax, real property than other assets; and a head (poll) tax is even easier to implement. It is not surprising, therefore, that the first direct levies were head and land taxes.
Although taxation has a long history, it played a relatively minor role in the ancient world. Greek and Roman consumption taxes were imposed. Tariffs—taxes on imported goods—were often of considerably more importance than internal excises so far as the production of revenue went. As a means of raising additional funds in time of war, taxes on property would be temporarily imposed. For a long time, these taxes were confined to real property, but later they were extended to other assets. Real estate transactions also were taxed. In Greece free citizens had different tax obligations from slaves, and the tax laws of the Roman Empire distinguished between nationals and residents of conquered territories.
Early Roman forms of taxation included consumption taxes, customs duties, and certain “direct” taxes. The principal of these was the tributum, paid by citizens and usually levied as a head tax; later, when additional revenue was required, the base of this tax was extended to real estate holdings. In the time of Julius Ceaser, a 1 percent general sales tax was introduced (centesima rerum venalium). The provinces relied for their revenues on head taxes and land taxes; the latter consisted initially of fixed liabilities regardless of the return from the land, as in Persia and Egypt, but later the land tax was modified to achieve a certain correspondence with the fertility of the land, or, alternatively, a 10th of the produce was collected as a tax in kind (the tithe). It is interesting to note that Rome had an inheritance tax of 5% at first, but later raised it to 10%. However, close relatives of the deceased were exempt. For a long time tax collection was left to middlemen, or “tax farmers,” who contracted to collect the taxes for a share of the proceeds; under Caesar collection was delegated to civil servants.
In the Middle Ages many of these ancient taxes, especially the direct levies, gave way to a variety of obligatory services and a system of “aids” (most of which amounted to gifts). Market fees and transit duties, which are charges on goods that pass through a particular nation, were the primary indirect taxes. In the cities the concept developed of a tax obligation encompassing all residents: the burden of taxes on certain foods and beverages was intended to be borne partly by consumers and partly by producers and tradesmen. During the later Middle Ages some German and Italian cities introduced several direct taxes: head taxes for the poor and net-worth taxes or, occasionally, crude income taxes for the rich. (The income tax was administered through self-assessment and an oath taken before a civic commission.) Taxes on land and on houses gradually increased.
Taxes have been a major subject of political controversy throughout history, even before they constituted a sizable share of the national income. The American colonies' rebellion against Great Britain, in which the colonists refused to pay taxes imposed by a Parliament in which they had no say, is a well-known example; hence, the slogan "No taxation without representation." Another example is the 1789 French Revolution, in which the uneven distribution of tax burdens played a significant role. Wars have influenced taxes much more than taxes have influenced revolutions. Many taxes started out as "temporary" war measures, like the income tax, which was first implemented in Great Britain in 1799, and the turnover or purchase tax, which was implemented in Germany in 1918 and Great Britain in 1940. Similarly, the withholding method of income tax collection began as a wartime innovation in France, the United States, and Britain. World War II converted the income taxes of many countries from upper-class taxes to mass taxes.
It is hardly necessary to mention the role that tax policies play in peacetime politics, where the influence of powerful, well-organized pressure groups is great. Arguments for tax reform, particularly in the area of income taxes, are perennially at issue in the domestic politics of many countries.
Current trends The development of taxation in recent times can be summarized by the following general statements, although allowance must be made for considerable national differences: The authority of the sovereign to levy taxes in a more or less arbitrary fashion has been lost, and the power to tax now generally resides in parliamentary bodies. The level of most taxes has risen substantially and so has the ratio of tax revenues to the national income. Taxes today are collected in money, not in goods. Tax farming—the collection of taxes by outside contractors—has been abolished, and taxes are instead assessed and collected by civil servants. (On the other hand, banks in many less developed nations have recently been contracted to collect taxes as a way to overcome the inefficiency of government agencies. In addition, some countries are outsourcing the administration of customs duties.)
There has also been a reduction in reliance on customs duties and excises. Many countries increasingly rely on sales taxes and other general consumption taxes. The introduction of value-added taxes in place of turnover taxes was a significant development in the latter half of the 20th century. Taxes on the privilege of doing business and on real property lost ground, although they have persisted as important revenue sources for local communities. The absolute and relative weight of direct personal taxation has been growing in most of the developed countries, and increasing attention has been focused on VAT and payroll taxes. At the end of the 20th century the expansion of e-commerce created serious challenges for the administration of VAT, income taxes, and sales taxes. The problems of tax administration were compounded by the anonymity of buyers and sellers, the possibility of conducting business from offshore tax havens, the fact that tax authorities cannot monitor the flow of digitized products or intellectual property, and the spate of untraceable money flows.
Income taxation (of individuals and of corporations), payroll taxes, general sales taxes, and (in some countries) property taxes bring in the greatest amounts of revenue in modern tax systems. The income tax has ceased to be a “rich man’s” tax; it is now paid by the general populace, and in several countries, it is joined by a tax on net worth. The emphasis on the ability-to-pay principle and on the redistribution of wealth—which led to graduated rates and high-top marginal income tax rates—appears to have peaked, having been replaced by greater concern for the economic distortions and disincentives caused by high tax rates. A good deal of fiscal centralization occurred through much of the 20th century, as reflected in the kinds of taxes levied by central governments. They now control the most important taxes (from a revenue-producing point of view): income and corporation taxes, payroll taxes, and value-added taxes. Yet, in the last decade of the 20th century, many countries experienced a greater decentralization of government and a consequent devolution of taxing powers to subnational governments. Proponents of decentralization argue that it can contribute to greater fiscal autonomy and responsibility, because it involves states and municipalities in the broader processes of tax policy; merely allowing lower-level governments to share in the tax revenues of central governments does not foster such autonomy.
Although it is difficult to make general distinctions between developed and less-developed countries, it is possible to detect some patterns in their relative reliance on various types of taxes. For example, developed countries usually rely more on individual income taxes and less on corporate income taxes than less-developed countries do. In developing countries, reliance on income taxes, especially on corporate income taxes, generally increases as the level of income rises. In addition, a relatively high percentage of the total tax revenue of industrialized countries comes from domestic consumption taxes, especially the value-added tax (rather than the simpler turnover tax). Social security taxes—commonly collected as payroll taxes—are much more important in developed countries and the more-affluent developing countries than in the poorest countries, reflecting the near lack of social security systems in the latter. Indeed, in many developed countries, payroll taxes rival or surpass the individual income tax as a source of revenue. Demographic trends and their consequences (in particular, the aging of the world’s working population and the need to finance public pensions) threaten to raise payroll taxes to increasingly steep levels. Some countries have responded by privatizing the provision of pensions—e.g., by substituting mandatory contributions to individual accounts for payroll taxes.
Taxes in general represent a much higher percentage of national output in developed countries than in developing countries. Similarly, more national output is channeled to governmental use through taxation in developing countries with the highest levels of income than in those with lesser incomes. In point of fact, the tax systems of the developing nations with the highest income levels share more similarities with those of developed nations than they do with those of the least developed nations. Distribution of tax burdens
Various principles, political pressures, and goals can direct a government’s tax policy. What follows is a discussion of some of the leading principles that can shape decisions about taxation.
Cost-effectiveness
The costs of assessing, collecting, and controlling taxes should be kept to the lowest level consistent with other goals of taxation. This principle is of secondary importance in developed countries, but not in developing countries and countries in transition from socialism, where resources needed for compliance and administration are scarce. It is clear that cost considerations should not override equity and economic rationality. The costs to be minimized include not only government expenses but also those of the taxpayer and of private fiscal agents such as employers who collect taxes for the government through the withholding procedure.
Horizontal equity
The principle of horizontal equity assumes that persons in the same or similar positions (so far as tax purposes are concerned) will be subject to the same tax liability. This equality principle is frequently ignored in practice, whether intentionally or unintentionally. Intentional violations are usually motivated more by politics than by sound economic policy (e.g., the tax advantages granted to farmers, home owners, or members of the middle class in general; the exclusion of interest on government securities). Debate over tax reform has often centered on whether deviations from “equal treatment of equals” are justified.
The benefit principle
Under the benefit principle, taxes are seen as serving a function similar to that of prices in private transactions; that is, they help determine what activities the government will undertake and who will pay for them. If this principle could be implemented, the allocation of resources through the public sector would respond directly to consumer wishes.
In point of fact, putting the benefit principle into practice for the majority of public services is difficult due to the fact that most citizens have no desire to pay for a publicly provided service—like a police department—unless they can be excluded from the benefits of the service. The benefit principle is utilized most successfully in the financing of roads and highways through levies on motor fuels and road-user fees. Payroll taxes used to finance social security may also reflect a link between benefits and “contributions,” but this link is commonly weak, because contributions do not go into accounts held for individual contributors.
Economic efficiency
The requirement that a tax system be efficient arises from the nature of a market economy. Although there are many examples to the contrary, economists generally believe that markets do a fairly good job in making economic decisions about such choices as consumption, production, and financing. Thus, they feel that tax policy should generally refrain from interfering with the market’s allocation of economic resources. That is, taxation should entail a minimum of interference with individual decisions. It should not discriminate in favor of, or against, particular consumption expenditures, particular means of production, particular forms of organization, or particular industries. Naturally, this does not preclude major social and economic objectives from taking precedence over these considerations. It may be desirable, for example, to impose taxes on pollution as a means of protecting the environment.
Economists have developed techniques to measure the “excess burden” that results when taxes distort economic decision making. The basic notion is that if goods worth $2 are sacrificed because of tax influences in order to produce goods with a value of only $1.80, there is an excess burden of 20 cents. A more nearly neutral tax system would result in less distortion. Thus, an important postwar development in the theory of taxation is that of optimal taxation, the determination of tax policies that will minimize excess burdens. Because it deals with highly stylized mathematical descriptions of economic systems, this theory does not offer easily applied prescriptions for policy, beyond the important insight that distortions do less damage where supply and demand are not highly sensitive to such distortions. Attempts have also been made to incorporate distributional considerations into this theory. They face the difficulty that there is no scientifically correct distribution of income.
Ease of administration and compliance
In discussing the general principles of taxation, one must not lose sight of the fact that taxes must be administered by an accountable authority. There are four general requirements for the efficient administration of tax laws: clarity, stability (or continuity), cost-effectiveness, and convenience. Administrative considerations are especially important in developing countries, where illiteracy, lack of commercial markets, absence of books of account, and inadequate administrative resources may hinder both compliance and administration. Under such circumstances the achievement of rough justice may be preferable to infeasible fine-tuning in the name of equity.
Stability
Tax laws should be changed seldom, and, when changes are made, they should be carried out in the context of a general and systematic tax reform, with adequate provisions for fair and orderly transition. Frequent changes to tax laws can result in reduced compliance or in behavior that attempts to compensate for probable future changes in the tax code—such as stockpiling liquor in advance of an increased tariff on alcoholic beverages.
Clarity
Tax laws and regulations must be comprehensible to the taxpayer; they must be as simple as possible (given other goals of tax policy) as well as unambiguous and certain—both to the taxpayer and to the tax administrator. While the principle of certainty is better adhered to today than in the time of Adam Smith, and arbitrary administration of taxes has been reduced, every country has tax laws that are far from being generally understood by the public. This not only results in a considerable amount of error but also undermines honesty and respect for the law and tends to discriminate against the ignorant and the poor, who cannot take advantage of the various legal tax-saving opportunities that are available to the educated and the affluent. At times, attempts to achieve equity have created complexity, defeating reform purposes.
Economic goals
The primary goal of a national tax system is to generate revenues to pay for the expenditures of government at all levels. Because public expenditures tend to grow at least as fast as the national product, taxes, as the main vehicle of government finance, should produce revenues that grow correspondingly. Income, sales, and value-added taxes generally meet this criterion; property taxes and taxes on nonessential articles of mass consumption such as tobacco products and alcoholic beverages do not.
Convenience
Payment of taxes should cause taxpayers as little inconvenience as possible, subject to the limitations of higher-ranking tax principles. Governments often allow the payment of large tax liabilities in installments and set generous time limits for completing returns.
Some economists propose tax policies to promote economic growth. This approach may imply a qualitative restructuring of the tax system (for example, the substitution of taxes on consumption for taxes on income) or special tax advantages to stimulate saving, labor mobility, research and development, and so on. There is, however, a limit to what tax incentives can accomplish, especially in promoting economic development of specific industries or regions. An emphasis on economic growth implies the need to avoid high marginal tax rates and the tax-induced diversion of resources into relatively unproductive activities.
In addition to the substitution effect discussed above, one must take into account the income effect. When taxation reduces real income, consumption of certain goods and services (and of leisure) will be reduced, because people have less money to spend. Furthermore, if a tax causes a significant redistribution of real income and if different income classes have different propensities to save and different patterns of consumption, then the income redistribution will influence the demand for various goods, the supply of labor, and the demand for various resources.
Other considerations affect tax shifting, but they are derived from the basic principle of substitution. The extent of shifting may vary over time, depending on how long it takes to adjust consumption patterns, reallocate land and capital, retrain labor, and so on. The most challenging users and suppliers will bear the greatest financial burden.