This article describes canons of TAXation and describes characteristics of a ‘good TAX’. It also explains three different TAX systems including progressive, proportional and regressive. Finally, it introduces the Incentive Effect.
The canons of TAXation
Nobody wishes to pay TAX, yet without it society would have to do without many things taken for granted, such as the provision of public security services. Most societies have been levied TAXes for many centuries, yet often TAXes were implemented inefficiently or unfairly.
In 1776, Adam Smith stated that a ‘good TAX’ should have the following characteristics:
- Cost of collection should be low compared to the income generated.
- The amount to be paid and the time of collection should be clear to the TAX payer.
- The method of payment and the time to pay should be convenient to the TAX payer.
- The amount to pay should be set according to the ability of the individual TAX payer to pay.
In addition to the guidelines laid down by Adam Smith, modern economists have added some additional characteristics to be more useful for a modern global environment.
- TAX should cause minimal loss to economic activity and should not reduce efficiency.
- The domestic TAX system should be compatible with foreign systems.
- TAX should change automatically with price changes. In reality, this normally means that TAXes are imposed as percentages, and not as absolute amounts. Setting TAXes as percentages means that the actual amount of TAX that needs to be paid will increase proportionally with inflation.
Major TAX systems
A TAX system looks at how all the TAXes in an economy affect households in society. Some TAX systems are better for the poorer households in society; whereas, some TAX systems are better for the richer members of society. TAX systems can be regarded as:
- Proportional
- Progressive
- Regressive
TAXes which charge the wealthy more are called progressive TAXes while TAXes which charge the poor more are called regressive TAXes. And, if they charge people in society equally, they are known as proportional TAXes.
1. Proportional TAX systems
In a proportional system the percentage of income paid as TAX remains the same as income rises.
This is relatively easy to calculate and some may consider it to be fair. Some economies’ TAX systems may be seen as relatively proportional, as the effects of a combination of regressive and progressive TAXes may cancel each other out. There is no clear example of an individual TAX that is proportional, though some argue that VAT is proportional.
Example: A shopkeeper earning £10,000 pays £2,000 (20%) of their income in TAX. A nurse earning £25,000 pays £5,000 (20%) of their income in TAX. A lawyer earning £50,000 pays £10,000 (20%) of their income in TAX.
2. Progressive TAX systems
In a progressive TAX system the percentage of income paid as TAX rises as income rises.
Many economies use this type of system, or at least include some progressive TAXes, in order to redistribute income. In the UK, income TAX is a progressive TAX.
Example: A shopkeeper earning £10,000 pays £1,500 (15%) of their income in TAX. A nurse earning £25,000 pays £5,000 (20%) of their income in TAX. A lawyer earning £50,000 pays £12,500 (25%) of their income in TAX.
3. Regressive TAX systems
In a regressive system the percentage of income paid as TAX decreases as income rises.
Many economies try to avoid a tax system being regressive overall, though some of the TAXes within the system may be regressive. Many argue that the UK’s ‘council TAX’ is a regressive TAX.
Example: A shopkeeper earning £10,000 pays £2,500 (25%) of their income in TAX. A nurse earning £25,000 pays £5,000 (20%) of their income in TAX. A lawyer earning £50,000 pays £7,500 (15%) of their income in TAX.
Direct TAXation and the Incentive Effect
Direct TAXes can have an effect on an individual’s incentive to work.
- The ‘income effect’ is where TAX reduces incomes and so people choose to work more in order to compensate for the loss of disposable income.
- The ‘substitution effect’ is where TAX reduces incomes and so the opportunity cost of leisure is reduced, and therefore people choose to work less as they view the benefits of leisure to be greater than the benefits of working.
An example of how this is useful information to a government is labor force participation rates. In the UK, efforts were made to encourage women to return to work after having a family. Though there are now more families where the husband is not the primary earner, this was not true in the past. Governments needed to set TAXes so that secondary family incomes were worthwhile earning. If TAXes were too great, then many women interested in returning to work may not have done so.
In summary, TAXation allows the government to provide necessary services that the public would not, or could not, pay for and access otherwise. They can also be used to make a more equitable society, and to maintain a higher standard of living.
Adam Smith created the canons of TAX as a guide to making useful and fair TAXes. There are three major TAX systems. An individual TAX within a system may also be reviewed as to whether it is proportional, progressive or regressive.
