Public Finance: Taxation

Taxation

• process which the State imposes, assesses, and collects taxes

• used to raise funds for government operations and public needs

• contributions are required by law

• strongest among the 3 inherent powers of state

Inherent Powers of State

• natural power of every sovereign State

• not granted by the people or Constitution

  • Taxation

  • Power of Eminent Domain

  • Police Power

Power of Eminent Domain

takes private property for public use with just compensation

Police Power

regulates persons and property for general welfare

Nature of the Power of Taxation

1. Inherent in sovereignty - may be exercised even if not expressly granted by the Constitution

2. Legislative in character - only the legislature compose taxes

3. Subject to constitutional & inherent limitations - not an absolute power

Characteristics of Tax

1. Enforced contribution

2. Proportionate in character

3. Generally payable in money

4. Levied on persons, property, or rights/privileges

5. Territorial in scope

6. Created by law

7. For public purpose

Purposes of Taxation

• lifeblood of the State

• Primary Purpose

  • Revenue/Fiscal Purpose - raise funds for necessary government expenses

• Secondary Purpose

  • Regulatory Purpose - regulates activities, products, or behaviors and promotes general welfare

  • Compensatory Purpose - reduction of social inequality, economic growth, and protect local industries against unfair competition

Principles of Taxation

• fundamental guidelines that help governments design and administered a tax system that is fair, clear, convenient, and efficient, while generating sufficient revenue for public needs

  • 4 Canons of Taxation by Adam Smith

  • Additional Principles by Charles F. Bastable

Adam Smith

• Scottish philosopher & economist

• Father of Modern Economics

• studied at University of Glasgow and the University of Oxford

• The Wealth of Nations (1776)

  • 4 Canons of Taxation

4 Canons of Taxation by Adam Smith

• guidelines that describe the qualities of a good tax system and help ensure that tax collection is fair, clear, convenient, and efficient

• Smith identified 4 classic canons of taxation:

  • Equity

  • Certainty

  • Convenience

  • Economy

Canon of Equity

• taxpayers should contribute according to their ability to pay

• those with greater financial capacity should generally bear a greater tax burden

• promotes fairness and prevents excessive burden on taxpayers with lower capacity

Canon of Certainty

• the amount of tax to be paid should be clear

• time and manner of payment should be clearly established

• prevents taxation from becoming arbitrary or unpredictable

Canon of Convenience

• taxes should be collected at a convenient time for taxpayers

• method of payment shouldn't be accessible and manageable

• makes it easier for taxpayers to comply with their obligations

Canon of Economy

• the cost of collecting and administering taxes should be kept low

• tax collection should ve efficient and avoid unnecessary expenses

• minimizes unnecessary costs for both the government and taxpayers

Additional Principles by Charles F. Bastable

1. Canon of Elasticity

2. Canon of Productivity

3. Canon of Simplicity

4. Canon of Diversity

5. Canon of Expediency

Canon of Elasticity

tax system should be flexible enough to generate more revenue when people's income or the economy grow

Canon of Productivity

a tax should generate enough revenue for the government without harming economic production

Canon of Simplicity

tax system should be clear, understandable, and not unnecessarily complicated

Canon of Diversity

government should collect taxes from different sources instead of replying on only one type of tax

Canon of Expediency

taxes should be practical and appropriate based on the country's economic, social, and political conditions

3 Canons of a Sound Tax System

1. Fiscal Adequacy

2. Theoretical Justice or Equality

3. Administrative Feasibility

Fiscal Adequacy

tax revenues must be sufficient to meet public expenditures and government needs without excessive borrowing

Theoretical Justice or Equality

taxation must be equitable and based on the taxpayer’s ability to pay

Administrative Feasibility

tax laws must be clear, easy to execute, and efficient to monitor and enforce

Inherent Limitations of Taxation

1. Public Purpose

2. Territoriality (Situs)

3. Non-Delegability

4. International Comity

5. Government Exemption

Public Purpose

taxes must be levied for a public purpose, not private individuals

Territoriality (Situs)

the taxing power is limited to persons, properties, or transactions within the jurisdiction of the Philippines

Non-Delegability

taxing power belongs purely to Congress and cannot be passed to the executive or judicial branches

International Comity

taxation must respect international treaties and foreign sovereignties

Government Exemption

agencies doing essential government functions are tax-exempt (the government cannot tax itself)

Taxation Theories

• fundamental principles and ideas that explain the basis and purpose of taxation

• explain why the government has the authority to collect taxes and how the tax burden should be fairly shared among taxpayers

• they answer key questions:

  • why does the government have the power to tax?

  • why are people required to pay taxes?

  • what is the purpose of taxation?

  • how should the tax burden be distributed fairly?

  • what do taxpayers receive in return?

• Lifeblood Theory

• Necessity Theory

• Benefits-Received Theory

• Ability-to-Pay Theory

• Symbiotic Relationship Theory

Lifeblood Theory

• taxes are the lifeblood of the government

• it highlights the importance of prompt and effective tax collection

• taxes are indispensable for government survival without them, the State cannot function

• however, the power to tax is not unlimited; taxation must follow the Constitution and the law and respect taxpayer rights

• Key Limitations:

  • Uniformity Rule

  • Due Process & Equal Protection

  • Public Purpose Doctrine

• public services, infrastructure, education & healthcare, and peace, order, & national security

Necessity Theory

• taxation is a necessary burden to preserve the State’s existence

• power to tax is an inherent attribute of sovereignty, the government cannot exist or function without raising revenue to finance its expenses

• in the Philippines, this is consistent with Article II, Section 4 of the 1987 Constitution, which states that the prime duty of the government is to serve and protect people

  • TRAIN Law (RA 10963) - increased excise taxes to fund infrastructure and social programs

Lifeblood Theory VS Necessity Theory

• Meaning:

  • LT - taxes are the lifeblood of the government

  • NT - taxes are necessary for the government to exist and function

• Main Focus:

  • LT - continuous flow of tax revenue

  • NT - need for taxation

• Purpose:

  • LT - to keep the government operating continuously

  • NT - to provide the government with resources to perform its duties

• Emphasis:

  • LT - importance of tax collection

  • NT - reason why taxation is necessary

• Question:

  • LT - what keeps the government function?

  • NT - why does the government need taxes?

Benefits-Received Theory

• refers to a theory of income tax fairness whereby individuals or businesses should pay taxes in proportion to the government services & public goods they receive

• promotes fairness in taxation by linking tax contributions to the benefits obtained from the government

• more benefits = greater tax contribution

• less benefits = smaller tax contribution

Ability-to-Pay Theory

• taxpayers should contribute according to their financial or economic capacity

• this approach to taxation is based on the just, fair, and equal sacrifice of taxation

• promotes progressive taxation and is consistent with the Constitution’s mandate for fair and equitable taxation

• high income = higher tax burden

• low income = lighter tax burden

• how’s ability to pay measure?

  • income

  • wealth or proper

  • consumption

Progressive Taxation

• tax system is progressive when the tax rate increases as taxable income increases

  • lower-income taxpayers → lower tax rates

  • higher-income taxpayers → higher tax rates

• tax burden increases according to ability to pay

Justification for Ability-to-Pay Theory

• Equal Sacrifice

  • everyone should contribute to taxation in a fair and reasonable way

  • its goal is to make the burden of paying taxes fair among tax payers

• Law of Diminishing Marginal Utility of Income

  • value or usefulness of additional money is greater for a poor person than for a rich person

  • people with higher incomes can be taxed more without experiencing the same level of hardship

• Interpretation of Faculty

  • a person’s ability to earn, spend, and contribute depends on their income and wealth

Symbiotic Relationship Theory

• Reciprocity Theory

• taxation is based on a mutual relationship between the government and citizens

• citizens pay taxes = government provides protection, services, and public benefits

• both the government and citizens depend on each other

• people pay VAT = government builds hospitals and schools that everyone can use

How does the Symbiotic Relationship Theory Work?

• Citizens

  • pay taxes

  • follow tax laws

  • support government programs

  • participate in society

  • contribute to public funds

• Government

  • collect taxes

  • provides public services

  • provides protection and security

  • builds infrastructure

  • promotes public welfare

Taxes in the Philippines

1. Income Tax

2. Business Tax

3. Withholding Tax

4. Transfer Tax

5. Other Taxes

Income Tax

• imposed by the government on income earned by individuals and businesses

  • Business Income Tax

  • Fringe Benefit Tax

  • Compensation Income Tax

  • Capital Gains Tax

Business Income Tax

• taxes imposed on certain business activities & transactions

  • Percentage Tax

  • Value-Added Tax or VAT

Withholding Tax

1. Withholding Tax On Compensation

2. Expanded Withholding Tax

3. Final Withholding Tax

Withholding Tax On Compensation

• tax on employees’ salaries and wages, deducted by the employer based on graduated BIR tax rates

• credited against employee’s final tax liability

Expanded Withholding Tax

• tax payments to professionals, businesses, or rentals, withheld by the payor at prescribed rates

• rates vary (ranging 5% to 15%)

Final Withholding Tax

• tax on passive income like interest, dividends, and royalties, withheld at a fixe rate and considered final

Transfer Tax

1. Donor’s Tax

2. Estate Tax

3. Documentary Stamp Tax

4. Excise Tax

Donor’s Tax

• tax on donations or gifts, or gratuitous transfer of property between living persons

• Net Gift - net economic benefit received after allowable deductions

Estate Tax

• a tax on the right of a deceased person to transmit their estate to lawful heirs and beneficiaries

• it is not a tax on the property itself, but on the privilege of transferring ownership upon death

• under the TRAIN Law in the Philippines, the estate tax uses a flat rate of 6% on the next taxable estate

• Net Estate - total value of property after allowable deduction

Documentary Stamp Tax

• tax on documents, instruments, loan agreements a paper evidencing the acceptance, assignment, sale or transfer of an obligation, rights, or property incident thereto

  • charged on bank promissory notes

  • deed of sale and deed of assignment on transfer of shares of corporate stock ownership

Excise Tax

• tax imposed on goods manufactured or produced in the Philippines for domestic sale or consumption or any other disposition

• imposed on things that are imported

Local Taxes

• LGUs are given the authority to create their own sources of revenue and to impose taxes, fees, and charges within their respective jurisdictions

• the authority of each LGU to impose taxes is subject to the provisions and limitations provided by law

• different levels of local government have different taxing powers

• Province Taxes

• Municipal Taxes

• Community Tax

• Barangay Taxes & Fees

Provinces Taxes

1. Tax on Transfer of Real Property Ownership

2. Tax on Business of Printing and Publication

3. Franchise Tax

4. Tax on Sand, Gravel, and Other Quarry Resources

5. Professional Tax

6. Amusement Tax

7. Annual Fixed Tax on Delivery Trucks or Vans

Tax on Transfer of Real Property Ownership

• imposed when ownership or title to a real property is transferred from one person to another

• a transfer may occur through the sale, donation, barter, or any other legal method of transferring ownership

• real property generally includes land, buildings, and other properties permanently attached to the land

Tax on Business of Printing and Publication

• imposed on persons or businesses engaged in the printing and/or publication of various materials

• may include books, cards, posters, leaflets, handbills, certificates, receipts, pamphlets, and other similar materials

Franchise Tax

• imposed on businesses that operate under a franchise

• a franchise generally refers to a special privilege or authority granted to a business to operate a particular services or activity

Tax on Sand, Gravel, and Other Quarry Resources

• imposed on the extraction of natural resources such as ordinary stones, sand, gravel, earth, and other quarry materials

• these resources may be extracted from public lands or from the beds of seas, lakes, rivers, streams, creeks, and other public waters within the territorial jurisdiction of the province

Professional Tax

annual tax imposed on individuals who are engaged in the practice of a profession that requires a government examination or license

Amusement Tax

• imposed on proprietors, lessees, or operators of places of amusement

• may include theaters, cinemas, concert halls, circuses, boxing stadiums, and other similar establishments or venues

Annual Fixed Tax on Delivery Trucks or Vans

• may be imposed on vehicles used by manufacturers, producers, wholesalers, dealers, or retailers for the delivery or distribution of certain products within the province

  • distilled spirits, fermented liquors, soft drinks, cigars, cigarettes, and other products that may be determined by the Sangguniang Panlalawigan

Municipal Taxes

1. Business Taxes

2. Community Tax

Business Taxes

1. Manufacturers, Assemblers, Repackers, Processors, Brewers, Distillers, Rectifiers, and Compounders Taxes

2. Wholesalers, Distributors, Dealers, and Exporters

3. Fees and Charges on Business and Occupation

Manufacturers, Assemblers, Repackers, Processors, Brewers, Distillers, Rectifiers, and Compounders Taxes

may impose taxes on businesses engaged in manufacturing, assembling, repacking, processing, brewing, distilling, rectifying, or compounding products

Wholesalers, Distributors, Dealers, and Exporters

• Tax on Business of Printing and Publication is imposed on persons or businesses engaged in the printing and/or publication of various materials

• these may include books, cards, posters, leaflets, handbills, certificates, receipts, pamphlets, and other similar materials

Fees and Charges on Business and Occupation

• municipalities may impose and collect reasonable fees and charges related to businesses, occupations, professions, and other activities

• these fees may be collected to cover the costs of regulation, inspection, and licensing

• before a person or business is allowed to operate legally, the local government may require compliance with certain requirements and the payment of the necessary fees

Community Tax

• imposed on individuals who are 18 years old or older and meet certain conditions provided by law

  • regularly employed on a wage or salary basis for at least 30 consecutive working days during a calendar year

  • engaged in a business or occupation

  • own real property with an aggregate assessed value of at least 1,000 pesos

  • required by law to file an income tax return

Barangay Taxes and Fees

1. Tax on Stores or Retailers

2. Service Fees or Charges

3. Barangay Clearance Fee

Tax on Stores or Retailers

• barangays may impose taxes on stores or retailers with fixed business establishments that fall within the gross sales or receipts limits provided by law

• tax rate imposed by the barangay may not exceed 1% of the gross sales or receipts

Service Fees or Charges

barangays may collect service fees or charges for services that may provide to residents or for the use of barangay-owned properties and facilities

Barangay Clearance Fee

• barangays may collect a reasonable fee for the issuance of a barangay clearance

• this document serves as proof that an individual or business has complied with certain barangay requirements

Deadweight Loss of Taxes

• economic inefficiency that occurs when a new tax reduces market transactions and overall economic welfare

  • Transaction

  • Total Surplus

  • Deadweight Loss

Transaction

• exchange between a buyer and a seller

• Buyer - wants to purchase a good/service

• Seller - wants to sell a good/service

• Price - agreed amount

• Exchange - both sides expect to benefit

  • A buyer is willing to pay 500 pesos while a seller is willing to sell for 300, a mutually beneficial transaction can happen

• people trade because both sides expect to benefit, the difference represents potential economic benefits

Total Surplus

• the benefit from trade

• Total Surplus - measures the total economic benefit created by a transaction, consumer surplus + producer surplus

• Consumer Surplus - what the buyer gains, willingness to pay minus the actual price

• Producer Surplus - what the seller gains, actual price minus minimum willingness to accept

Deadweight Loss

• loss gain from trade

• foregone surplus from transactions that no longer occur, not necessarily money literally disappearing

• economic value lost when mutually beneficial transaction do not take place

  • buyer values product at 500 pesos, then seller can provide it for 300 pesos and potential benefit is 200

  • buyer doesn’t get the product, seller doesn’t receive payment, and 200 pesos potential benefit disappears

• potential transaction→ somethings prevent the trade → transaction does not happen → potential benefit is lost → deadweight loss

Causes of Deadweight Loss

1. Taxes - increase the cost of buying/selling which leads to fewer transactions

2. Price Controls - can create shortages or surpluses that some trades don’t happen

3. Monopoly - restricts output and raises price which leads to underproduction

4. Regulations/Restrictions - can make transactions more difficult or costly that leads to fewer beneficial trades

DWL on Supply & Demand Graph

• Before Tax

  • Quantity

  • Price

  • Demand Curve

  • Supply Curve

  • Equilibrium

    • Equilibrium Quantity

    • Equilibrium Price

• After Tax

  • Price paid by Consumer

  • Price received by Suppliers

  • Quantity after Tax

Effects of DWL of Tax

1. Reduced Market Transactions

2. Loss of Consumer and Producer Surplus

3. Uncollected Tax Revenues

4. Behavioral Inefficiency

Optimal Taxation

• design of a tax system that raises sufficient government revenue

• minimizes distortions in economic decisions

• aims to maximize social welfare

• balances revenue generation, redistribution, and economic efficiency

Principles of Optimal Taxation

1. Efficiency

2. Equity

3. Elasticity

4. Feasibility & Administerability

Efficiency

raise revenue while minimizing distortions to economic behavior

Equity

distribute the tax burden fairly based on principles such as ability to pay and benefits received

Elasticity

• consider how strongly taxpayers respond to changes in taxation

• Elastic Tax Base

  • greater behavioral response, greater potential distortion

• Inelastic Tax Base

  • smaller behavioral response, more predictable revenue

Feasibility & Administerability

ensure that taxes are practical to implement, enforce, and comply with

Trade-Off of Optimal Taxation

Efficiency vs. Equity

• a more progressive tax system may improve equity, but higher tax burdens can create greater efficiency costs

• a system focused heavily on efficiency may generate fewer distortions, but it may provide less redistribution

• Main Objective: find a balance where the benefits of fairness and revenue outweigh the economic costs of taxation

2 Fallacies of Optimal Taxation

1. Fallacy of Counting Distortions

2. Second-Best Fallacy

Fallacy of Counting Distortions

• assumes that fewer distortions is better taxation

• the number of distortions alone does not determine efficiency

• what matters is the magnitude and economic effects of each distortion

Second-Best Fallacy

• assumes that removing a distortion always improves efficiency

• some distortions may be unavoidable or impossible to eliminate

• removing one distortion may not improve welfare when other distortions remain

• tax policy should therefore consider how distortions interact across the economy

Optimal Taxation

posits a tax system should be chosen to maximize a social welfare function, the foundational frameworks established by Ramsey and Mirrlees should have the aspect of designing systems that are economically efficient, socially fair, and politically sustainable and the idea of an analytical tool like the Laffer Curve comes in practice

Key Models of Optimal Taxation

1. Ramsey Rule

2. Mirrlees Model

3. Atkinson-Stiglitz Theorem

4. Diamond-Mirrlees Theory

5. Laffer Curve

Ramsey Rule

• developed by economist Frank Ramsey in 1927

• gives highlight on the principle of elasticity and efficiency with the general rule of taxing goods in inverse proportion to their elasticity of demand and supply

• idea is to impose higher taxes on goods with inelastic demand or supply, while applying lower taxes on goods with elastic demand or supply

• minimizes economic distortion while still generating maximum revenue by taxing inelastic goods more heavily

• Inelastic Goods - higher tax rates as people will still buy or produce them such as medicine or fuel

• Elastic Goods - lower tax rates as people will stop buying or producing then if taxed too much like luxury items or leisure goods

What the Ramsel Rule May Not Account For?

• it promises efficiency but doesn't promise fairness as it increases the burden on poorer communities especially for acquiring basic necessities

• it only minimizes deadweight loss and doesn't consider all possible tax schemes to balance efficiency, equity, and practicality

• it is not popular with the general public what may seem efficient may not be efficient to their viewpoint as it may face public backlash and possible protest

Mirrlees Model

• developed by Nobel Prize winner James Mirrlees in 1971 as he discovered the challenge behind optimal taxation was information asymmetry

• there's an unobserved heterogeneity: the government cannot directly see ability, only the income or numbers of people report which depends on both ability and effort of the taxpayer

• the question now stands: How to design a tax system that balances the need for wealth redistribution with the loss of individual incentives to work?

• Mirrlees quoted that “the optimal redistribution occurs when there's a balance between the equity and improvements and the efficiency losses”

• found that the optimal top marginal tax rate is about 20% which justified flat tax or flat tax rate

• proved that the marginal tax rate on the highest-income earner should be 0

• full equality (everyone ending up with the same income after taxes) is impossible when ability is private information, it should have a workable balance of redistribution

The Revelation Principle

• under of the Mirrlees Model, the goal is to maximize social welfare, while respecting the hidden differences among taxpayers

• an ideal tax system may be an Incentive Compatibility Rule where the following are:

  • high-income earners are to work productively without trying to hide or reduce their income while low-income earners are not discouraged or unfairly burdened

  • everyone has an incentive to act in their best interest, rather than focusing on how to game the tax brackets

• allows the government to consider all feasible tax scheme under the information limits:

  • Nonlinear Taxes - tax rates that charge depending on income or consumption levels

  • Interdependent Taxes - taxes that vary depending on combinations of goods

  • Income-based Taxes - taxes on wages, capital gains or savings, not just commodities

  • Personal characteristics - age, family size, or health status could influence tax policy design

Atkinson-Stiglitz Theorem (1976)

• if income taxes are designed well, there’s no need for extra taxes on goods

• if your allowance is already taxed fairly, the government doesn’t need to tax your personal items differently, the income tax will do it job fairly

• simplifies tax systems, avoids distortion in consumption

Diamond-Mirrlees Theory (1971)

• government should avoid taxing production inputs, instead, they should tax only final goods and services after they are produced

• you don’t tax the cotton used to make shirts, let textile factories produce cheaply, then tax the shirts when they reach the store

• taxes are collected at the point of consumption, supporting growth while still raising revenue

Optimal Taxation in PH Setting

1. TRAIN Law (PIT) - mirrlees model, equity, work incentives, and boosting consumption, higher take-home pay, short-term drop in direct revenue

2. CREATE Act - mirrlees model, efficiency, FDI competitiveness, and expanding capital base, encourages business expansion, requires base broadening

3. VAT Policy (12%) - ramsey rule, broad-based, low-distortion revenue generation, stable tax base, requires targeted subsidies (4ps) to offset regressivity

4. EOPT Act - administerability, reducing compliance costs, lessening tax evasion, widens tax base, improves tax effort without rate increases

5. Pigouvian Taxes (Sin Taxes) - corrective taxation, aims in correcting negative externalities, encourages sustainable practices, raises revenue while reducing negative externalities

Laffer Curve

• introduced by Arthur Laffer in 1974 and was popular for its ease of sketch and simplicity to understand

• adopts a free-market approach of tax cutting where it displays the relationship between tax rates and tax revenue

• illustrates how changes in tax rates may affect the amount of revenue collected by the government

• a theoretical model of the relationship between tax rates and tax revenue

• to answer the core question of What is the tax rate that maximizes tax revenues?

• tax revenue = tax rate x tax base

• as tax rates change, the tax base (total taxable economic activity) expands or contracts in response to human behavior, work disincentives, and market incentives

• At 0% - revenue is zero because nothings is collected

• At 100% - revenue is zero because nobody participates in taxable activity

The Graph and Key Features of Laffer Curve

1. Horizontal Axis (X-axis): Tax Rate - percentage of taxable income or activity collected as tax, usually expressed from 0% to 100% in the theoretical model

2. Vertical Axis (Y-axis): Tax Revenue - amount of revenue generated by the government

3. Upward-Sloping - as the tax increases, tax revenue generally increases because the higher rate outweighs the reduction in taxable activity

4. Downward-Sloping - beyond T-star further increases in the tax rate may reduce total tax revenue

5. The Peak (T-Star) - tax rate at which the model reaches its maximum tax revenue

2 Major Regions of the Curve

1. Normal Zone (Before T*) - low to moderate tax rates, higher tax rates generally increase revenue, and tax disincentives remain relatively limited

   1. a moderate tax increase may generate additional revenue cause the higher rate outweighs the reduction in taxable activity

2. Prohibitive Zone (After T*) - higher tax rates generally reduce revenue, tax base may contract, and stronger disincentives and reduced compliance

   1. excessively high taxes may discourage investment, production, or reported income