15 July 2013 Written by  Yohannes Mesfin and Sisay Bogale

General Theories and Principles of Taxation

Taxation is the earliest and most prevalent form of government inter­ference with the economic life of individuals and business enter­prises. The right of the chief authority to collect taxes, and the general policy which determines who is to be taxed, how much the tax shall be, and for what purposes it shall be levied has always been a controversial issue. The tremendous increases in public spending accompanying recent depressions and war periods have brought the question of taxation to the mind of each and every citizen. Moreover, the extension of the powers of governments and the creation of modern greater states has necessitated larger revenue for the administration of states. As such, the development of general taxation was inevitable.

 

When dealing with taxation, it is unavoidable to have important and complicated questions popping up into our heads. Some common questions include those such as:

If public revenue contains returns from non-tax sources and from taxation, is it possible to increase the former?

Is it to the advantage of the common that this should be done?

When we take the revenue obtained by taxation, how ought the burden to be distributed?

 

The answers to questions like these will be governed by the view we take of the function of the State. Considering the possible solutions to such questions (issues) has led to the development of certain theories pertinent to taxation.

 

An individualistic theory would lead, so to speak, to man having as little as possible to do with the State. Every person needs, say, protection and justice, and experience shows that these can best be obtained in a society; the taxes he/she pays may be a quid pro quo, a payment for the services rendered. However, such a view was evidenced to lead to absurd conclusions. Does it not cost just as much to protect a man not blessed with very much of this world's goods as it does to protect a rich person? If we consider only real property, it may be that the cost of protecting it does not increase proportionately with the amount and, at any rate, “if security is to be sold like an ordinary commodity, there ought, on the strictest commercial principles, to be some allowance made to the purchaser of a large quantity." The requirement that everybody share an equal amount of revenue is equally absurd.

 

On the other hand, a State can be considered as the most definite institution in society; and, further, since from one point of view wealth has no meaning except in a society, the part played by that society in the production of wealth may be looked upon as making the State "the residual owner of all income which exceeds the requirements of maintenance and normal growth”. A further extension of the same idea would be for the State to attempt to level the existing large inequalities in the incomes of its individual members by a heavily graduated tax. Thus, the socialistic ideal is widely different from the individualistic one. Is it possible to arrive at the golden mean?

 

As a preliminary to this it seems necessary to get rid of any sort of a priori reasons for an individualistic or a socialistic view of the functions of government; it may be argued that it is impossible to lay down any general principles which apply to every case of State interference. Each example has to be judged on its own merits statistics can help us here, but it is difficult to see the use of applying any hard and fast rule. If this be the case, we reach the faculty or ability theory of taxation. Provided that the sole aim in imposing taxation is to obtain revenue, then a reasonable distribution of taxation could surely be based upon the citizens' ‘abilities to pay’. The difficulty comes in when we try to assign a definite meaning to this idea; at the present time, it is the most generally accepted theory, but possibly that is because it is so conveniently vague. ‘Ability to pay’ has at least three different and distinct meanings. We may consider it entirely from the point of view of equity or from that of the consumption, or of the production of wealth.

 

If taxation is to be levied solely to obtain revenue, then equality may be a very desirable ideal at which to aim. But what does equality mean? Obviously everybody should not pay an equal share of taxation, and there are three important possible forms of distribution which have been suggested from time to time; each is intended to secure equity and each supposed to be based on the ‘ability to pay’.

 

The first is the pure proportional form; taking income as the standard, it is laid down that the criterion of ability to pay would be attained by taxpayers paying in proportion to their income proportion being considered in the strict mathematical sense of the word. This is perhaps the view of Adam Smith, but surely it must be repudiated by common sense, as a single example will show. Suppose that a quarter of a man's income was required by the State; then a man earning 10 Birr a week would pay 25 cents, and the one getting 2 Birr a week would pay l0 cents each week; the first man might now no longer be able to keep a motor cycle, while the latter would hardly be able to feed his wife and family.

 

Such considerations as these have led men to think of a progressive or graduated form of distribution, in which the rate of taxation levied increases with the size of the income. But another aspect of the matter can well be brought in here. J. S. Mill says; “Equality of taxation”, therefore, as a maxim of politics, means equality of sacrifice. It means apportioning the contribution of each person towards the expenses of government, so that he/she shall feel neither more nor less inconvenience from his/her share of the payment than every other person experiences. But he/she is considering only the consumption aspect of income. He is asking, in effect, “How much ought a man to pay in taxation and how much ought he to have left for his own consumption?” But surely we ought to consider also his production as well as his consumption of wealth. “In estimating a man's faculty or ability to pay we must not alone think of the burden imposed on him in parting with his property or income, but we must also consider the opportunities he has enjoyed in securing that property or income. If this is so, we have a plain case that equity requires a graduated rate of taxation; many higher incomes (and the so-called “unearned” incomes) are obtained as the result of particular privileges particularly that of inheritance and this legal or social privilege enjoyed in the production of an individual's income increases its " ability to pay." The strongest argument against this graduated form of taxation seems to be that it checks saving. But so also, in a way, does any form of taxation; a progressive system affects most considerably the very large incomes, but it encourages saving among the middle classes and the people with relatively small incomes.

 

It should be noticed that although income and inheritance taxes are the particular ones to which graduation is most easily applicable, yet progression can also be realized to a certain extent by levying heavy taxes on luxuries and the better kinds of a number of articles. Thirdly, we come to a form of distribution which may be called a qualified proportional one. Here, once again taking income as the standard, "equality of sacrifice" can be obtained (it is said) by exempting a certain amount of income and levying a uniform or possibly a slightly graduated rate of tax on any income above that limit. This is, of course, the way in which our present income tax works, which allows "a personal allowance " of 135, or 225 " in the case of an individual whose wife is living with him/her to be free of income tax.

 

The two central principles of taxation relate to the impact of tax on efficiency concerned with the allocation of resources) and equity (concerned with the distribution of income). As the major principles of taxation in any system, it is worth taking an in-depth look at “efficiency” and “equity (fairness)”.

A good tax system should be efficient in that it should be able to waste as little money and resources as possible. Efficiency can be measured against three standpoints: administrative costs, compliance costs and excess costs. These three relate to the cost of operation of the tax system, to its flexibility and certainty. Administrative costs are the costs to the government (and ultimately to the taxpayer) of collecting tax revenue. In order to collect taxes, the government must hire collectors to collect the revenue; data entry clerks to process the tax returns; auditors to inspect questionable returns; lawyers to deal with disputes; and accountants to track the flow of money. All these costs are those that are incurred by the government to administer the tax system. Compliance costs, on the other hand, are the costs (other than the taxes themselves) of making tax payments to the government. In order to comply with their obligation to pay taxes, citizens are bound to incur certain costs. These compliance costs include not only the money that people spend on accountants, tax preparers and/or tax lawyers, but also the time spent in filing tax returns and keeping records. The third aspect of efficiency, excess burden, relates to tax-induced change in behavior displayed by tax payers. When the government levies taxes on goods, it distorts consumer behavior as people are bound to buy less of taxed goods and more of other goods. Thus the intrinsic value of goods is shadowed by the taxes which are imposed on the goods. In general the larger any of these costs get, the worse it is for efficiency.

 

The other major principle of taxation is that the burden of tax should be distributed fairly.Accordingly, equity or fairness is further highlighted by two principles: the ability-to-pay principle and the benefits principle. The ability-to-pay principle holds the idea that the amount of taxes that people pay should be based on their ability to pay. This principle implies two things:

Horizontal Equity: People in equal positions should be made to pay the same amount of taxes.

Vertical Equity: A tax system should distribute the burden of paying taxes fairly across people with different abilities to pay. Thus, people who earn more should pay more than those people who make less than them.