Public Sector Economics - 11. Principles of tax policy

• Benefit principle: states that the people who benefit from the government's expenditures should be the ones who pay for them.
  • Ability-to-pay principle: states that individuals should pay taxes in proportion to their ability to pay.
• Horizontal equity: two individuals earning the same income should pay the same amount in taxes.
  • Vertical equity: people with greater abilities to pay should pay more in taxes than those with lower abilities to pay.
• Tax systems can be classified according to the proportion of income that an individual taxpayer would pay in taxes as the taxpayer's income changes.
  • Proportional tax: a tax that is the same percentage of a taxpayer's income no matter what the level of income.
  • Progressive tax: a tax that is a larger percentage of the taxpayer's income as income rises.
  • Regressive tax: a tax that is a smaller percentage of the taxpayer's income as income lowers.
• Sumptuary tax: taxes designed to discourage the consumption of the taxed good.
• Equity and efficiency are important aspects of taxation.

Conclusion

• The development of tax policy in the real world is a complex process encompassing, a number of issues. A primary goal of tax policy is to raise revenues in as efficient a manner as possible. Another goal is to take full account of equity issues to make sure that the tax system is fair. From an economic standpoint, equity and efficiency underlie the basic principles of taxation.
• The benefit principle of taxation states that each individual should pay taxes in proportion to the benefits received from the government. Recall that the government produces many goods because the private sector cannot do so efficiently. One way to implement the benefit principle is to finance government output with user charges, but often such charges are not feasible. There may be other ways to levy taxes, however, that approximate the benefit principle of taxation.
• The ability-to-pay principle states that individuals should pay taxes in proportion to their ability to pay. This principle may generally be regarded as a tenet of fairness in taxation, like the benefit principle, but sometimes the benefit principle and the ability-to-pay principle may conflict. For example, an individual with several children in public schools may have a lower ability to pay taxes for public education than an individual with no children, but the individual with children is receiving a larger benefit from public education. According to the benefit principle, the person with the children should pay more in school taxes, but, according to the ability-to-pay principle, the person should pay less.
• There are two distinct concepts of equity that follow from the ability-to-pay principle of taxation-horizontal equity and vertical equity. Horizontal equity implies that individuals with an equal ability to pay should pay equal amounts of taxes. Although this principle seems relatively straightforward, questions raise as to whether individuals in different circumstances have equal abilities to pay. Does a person who chooses to have a large family have a lower ability to pay than the person who chooses not to have a family? Does a person who has high medical expenses have a lower ability to pay than an individual who has equally high home repair expenses? In this regard, the concept of horizontal equity becomes more difficult to apply in practice than in theory. The concept of vertical equity is even more difficult to apply, for although it suggests that people with a greater ability to pay should pay more in taxes, it does not specify how much more. Both proportional and progressive taxes satisfy the basic criteria of vertical equity in taxation, and some regressive taxes qualify as well.
• Sumptuary taxes are taxes that are deliberately designed to reduce the amount of a good consumed. Taxes on tobacco, alcohol, and gambling fall into this category. One motivation for taxing these goods is to raise revenue, to be sure, but the underlying rationale is that the consumption of these types of goods is undesirable and that a heavy tax can help to discourage their use. In this sense, the application of a sumptuary tax is distinctly normative.
• Despite the occasional difficulty in specifying concepts of equity in taxation, the importance of equity principles should not be minimized. Fairness in taxation is a generally agreed-upon goal, so a society must consider equity arguments in choosing its tax system.
• Although there is no way to scientifically determine the characteristics of a fair system of taxation, there are some normative principles that command substantial a agreement, and because ultimately the tax system is created through a democratic principle that relies on political agreement, normative principles of taxation must underlie the tax system.
• A full appreciation of the tax system requires that the political environment in which taxes are determined be understood along with the positive and normative principles that go into the shaping of tax polar. After all, tax policy is ultimately determined through the political process, so it would be naive to assume that tax issues are determined solely on equity and efficiency grounds without considering the incentives of those who shape the tax laws.
• This chapter and the previous one have introduced some basic principles of taxation and have laid a foundation for examining in detail actual taxes in the tax system, which will occur in the next several chapters. All these specific taxes can be evaluated in the context of the general principles of taxation presented here. Because individual taxes are all part of a comprehensive tax system, ultimately we must relate the various types of taxes to one another so that we can understand not only what the effects of individual taxes are but also how each of them relates to the others.

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