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Effective Taxation

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Effective Taxation

Have you ever wondered why there is a variety of taxes to pay? Why can't there be just one straightforward tax, say, income tax? It directly meets several criteria for effective taxation. It takes into account the ability to pay by observing earnings directly. Progressive rates can be adjusted to make it more equitable, and it has a pretty flexible collection and tax base. Well, it turns out that having only one tax can increase tax evasion, thereby compromising government revenue. Fairness concerns arise if income is the only tax base. Lastly, the economic output can be negatively impacted if incentives for work and entrepreneurship are altered in a single tax scenario. Is it possible then to decide on an effective taxation definition? How attainable is an effective taxation system? What are the characteristics of effective taxation? Well, you are in the right place, because this article will explain everything you need to know about it! Ready to dive deeper? Then keep scrolling!

Effective taxation definition

Effective taxation definition is not that straightforward. There are many factors at play that need to be taken into account when designing an effective tax system. To help you out with that, we divided these factors into five broad principles.

  • The five principles of effective taxation:
  • 1. Equity
  • 2. Efficiency
  • 3. Convenience
  • 4. Certainty
  • 5. Flexibility

An effective taxation system is a system that considers and fits the five principles: equity, efficiency, convenience, certainty, and flexibility.

But what do all these criteria mean? Let's find out!

Effective Taxation Effective Taxation StudySmarterEffective Taxation, Pixabay

Effective taxation characteristics

An effective taxation system is designed to take into account five essential characteristics or principles. Let's go over each of them in turn and try to understand them based on the personal and corporate income tax examples.

Effective Taxation: Equity Principle

Equity is broadly divided into horizontal and vertical equity. Vertical equity means that people who earn more would pay a more significant proportion of their income in tax than those who earn less, for example. Horizontal equity suggests that the effective tax rates must be the same for individuals with similar pre-tax income.But is this all there is to the equity principle? It's not all that simple! To achieve more significant equity, economists need to decide whether the tax needs to be progressive, regressive, or proportional.

To learn more about the different types of taxes, reach out for this article: Types of Taxes.

The U.S. federal income tax is progressive and consists of 7 brackets. In 2022 the lowest income bracket for single filers is 10% of taxable income not exceeding $10,275. For income over $539,900, a single filer would pay $162,718 plus 37% of the excess over and above $539,900.3

Last but not least, to achieve greater equity, the tax must be challenging to avoid. For most people employed by businesses, income taxes are already deducted when they receive their paycheck, making it difficult to avoid. Freelancers, however, have to report their income themselves, which makes it more difficult for the government to monitor and achieve compliance.

Vertical equity means that people pay taxes in proportion to their ability to pay.

Horizontal equity means that the individuals with similar pre-tax income pay the same amount in taxes.

Dive deeper into this topic in our articles:

- The Economics of Taxation

- Two Principles of Taxation

Effective Taxation: Efficiency Principle

The efficiency principle is primarily based on the idea of neutrality. Neutrality means that the imposition of the tax would not alter economic agents' incentives.As businesses are responsible for withholding income taxes on behalf of their employees, income tax brackets may alter their incentives to gradually increase workers' salaries. Instead, they may wait to postpone salary increases until it becomes substantial or worthwhile.Another aspect of efficiency is that the benefits of tax collection should be outnumbered by the costs. This is primarily achieved through the cost of tax collection being as low as possible so that the remaining revenue is substantial.

Availability of information plays a prominent role in tax efficiency. On the one hand, firms directly collect the tax numbers and send the reports to the government. On the other hand, using income as a proxy for the ability to pay may not be accurate enough, as the actual ability to pay is not directly observable.

Neutrality means that the imposition of the tax does not alter economic agents' incentives.

Effective Taxation: Convenience Principle

The convenience principle is based mainly on ideas of simplicity and understandability. The compliance rate will be higher if the tax is simple to understand.

Having multiple income tax brackets may improve equity. However, the convenience may decrease compared to a flat tax rate. People on fluctuating incomes may find it difficult to report their taxes. Multiple tax reliefs can lead to many filing additional forms to get tax refunds if mistakes happen.

Effective Taxation: Certainty Principle

Tax certainty primarily means that the tax will yield the revenue the government intended to collect. This means that the tax would be well-defined and will tax something feasible, like income, rather than something arbitrary, which is difficult to measure, like wealth.Additionally, the certainty principle implies that the tax system can adapt to fluctuating economic conditions. Income taxes work hand in hand with transfer payments through the mechanism of automatic stabilizers.When the economy is in a boom, income taxes will increase while transfer payments will fall, thereby stabilizing tax revenue. This also helps to regulate the level of aggregate demand in the economy. In contrast, when the economy is in a recession, income tax receipts fall, but transfer payments increase, stimulating aggregate demand.

Tax certainty means that the tax revenue for the government is stable and the tax system can adapt to the changing economic environment.

Effective Taxation: Flexibility Principle

According to the OECD, modern taxation systems should be flexible enough to adapt to varying economic and technological changes.4 Technological advancements may alter the way that the competition works in various market structures.

Suppose firms get enough information about their consumers to price discriminate better based on the consumer's price elasticity of demand. In that case, they can shift their corporate income tax incidence onto consumers through higher prices.If technological advancements make capital more flexible to be employed by businesses, then the workers would be disadvantaged. How so? Suppose firms would find it easier to substitute workers for capital. In that case, they can pay the workers less and therefore pay less in payroll taxes to the government.

Criteria for effective taxation

Criteria for effective taxation, or canons of taxation, were postulated by Adam Smith in his famous book - The Wealth of Nations.1 They were proposed slightly differently in the book, but the ideas were largely the same as today. He introduced the ability to pay principle, which means that the taxes should be levied in accordance with the person's ability to bear them. He emphasized that tax collection should certainly yield revenue rather than be arbitrary. The convenience to the taxpayer, alongside ease of collection and administering, was also mentioned. These universal principles apply to tax systems on regional as well as national levels. They are used in tax system design to this day! No wonder Adam Smith is regarded by many as the Father of contemporary economics!

Effective Taxation Adam Smith Portrait StudySmarterAdam Smith Portrait, Wikimedia Commons

Effective taxation system

An effective taxation system is a system that is founded on the five main principles: equity, efficiency, convenience, certainty, and flexibility. The difficulty in achieving these principles at once lies in the fact that there are trade-offs between them.Let's look at the possible trade-offs that may arise when designing an effective income tax system.Achieving vertical equity in income tax can be done by altering the tax brackets and the corresponding percentages of income that individuals in those brackets need to pay. Allowances and tax reliefs can aid those in the same income group with a lower ability to pay, improving horizontal equity.

Having children affects your ability to pay taxes as household spending increases. Families in the U.S. automatically receive a weekly allowance of between $200-$300 per child.2

Income tax is a progressive tax, which results in greater equity. However, the tax brackets can negatively impact individuals whose income fluctuates. The tax is collected, and deductions are accounted for in a given tax year.

A tax year in the U.S. coincides with the calendar year and runs from 1 January to 31 December. A tax year in the U.K. is between the 6 April to the 5 April the following year.

A person who earns a lot in a particular year but less in other years may end up paying a larger proportion of their income in tax. This is compared to if the tax was collected over a larger time horizon.

Imagine a recent college graduate - Anna. After college graduation, she worked for 3 years but then got married and went on maternity leave for 2 years. During her maternity leave, her company fired her, and she received no income. She did, however, pay income tax in the 3 years she was working. Her yearly tax rate might have been lower if the tax was payable over the 5-year period.

If businesses react by postponing salary increases, this would also alter workers' behavior. Knowing that they won't receive their salary increase any time soon, they may get disincentivized to work to their fullest potential and shirk instead. This may also affect workers' certainty about their future income and their intertemporal consumption smoothing. They may increase their preference for higher savings now, which can discourage economic growth in the short run.Last but not least, the aim to minimize tax avoidance inevitably introduces complexity to any tax system. This means that the principle of equity is achieved through reducing adherence to the convenience principle.It can be seen that achieving all the principles of an effective taxation system at once is not an easy task due to varying and complex trade-offs. Estimating how the tax would perform in a practical setting is not an easy task either. But we are sure that after reading this article, you will probably know more about an effective taxation system design than anyone in your class. Go on, then, and share this knowledge with the world!

Effective Taxation - Key takeaways

  • An effective taxation system is a system that considers and fits the five principles: equity, efficiency, convenience, certainty, and flexibility.
  • Vertical equity means that people pay taxes in proportion to their ability to pay. Horizontal equity means that the individuals with similar pre-tax income pay the same amount in taxes.
  • Neutrality means that the imposition of the tax does not alter economic agents' incentives.
  • Tax certainty means that the tax revenue for the government is stable and the tax system can adapt to the changing economic environment.
  • Achieving all the principles of an effective taxation system at once is not an easy task due to varying and complex trade-offs.

References

  1. Adam Smith, The Wealth of Nations (1776)
  2. The White House, The Child Tax Credit, 2022, https://www.whitehouse.gov/child-tax-credit/
  3. Forbes Advisor, 2021-2022 Tax Brackets and Federal Income Tax Rates, 2022, https://www.forbes.com/advisor/taxes/taxes-federal-income-tax-bracket/
  4. OECD (2014), "Fundamental principles of taxation," in Addressing the Tax Challenges of the Digital Economy, OECD Publishing, Paris, https://doi.org/10.1787/9789264218789-5-en

Frequently Asked Questions about Effective Taxation

An effective taxation system is a system that considers and fits the five principles: equity, efficiency, convenience, certainty, and flexibility.

The most effective tax system is the one that takes into account all the five tax system design principles while optimizing for their trade-offs.

The six characteristics of effective taxation are:
1. it is difficult to avoid
2. easy to understand
3. convenient to pay
4. low administrative cost
5. does not violate agents' incentives
6. adapts to changing economic conditions.

The three main criteria for effective taxes are:
1. efficiency
2. equity
3. certainty

An economist views an efficient tax through the canons of taxation postulated by Adam Smith in his famous book - The Wealth of Nations (1776).

Final Effective Taxation Quiz

Question

Explain what is meant by effective taxation?

Show answer

Answer

An effective taxation system is a system that considers and fits the five principles: equity, efficiency, convenience, certainty, and flexibility.

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Question

What are the two types of equity?

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Answer

The two types of equity are: horizontal and vertical equity.

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Question

What is vertical equity in tax system design?

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Answer

Vertical equity means that people pay taxes in proportion to their ability to pay.

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Question

What is horizontal equity in tax system design?

Show answer

Answer

Horizontal equity means that the individuals with similar pre-tax income pay the same amount in taxes.

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Question

What does neutrality of a tax mean?

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Answer

Neutrality means that the imposition of the tax does not alter economic agents' incentives.

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Question

What is the tax certainty principle?

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Answer

Tax certainty means that the tax revenue for the government is stable and the tax system can adapt to the changing economic environment.

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Question

Who was the first to postulate the criteria for effective taxation?

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Answer

Adam Smith

Show question

Question

Explain why achieving all the tax principles at once might be difficult?

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Answer

Achieving all the principles of an effective taxation system at once is not an easy task due to varying and complex trade-offs.

Show question

Question

Give an example of how horizontal equity is improved in the U.S. income tax system?

Show answer

Answer

Through benefit payments. Families in the U.S. automatically receive a weekly allowance of between $200-$300 per child.

Show question

Question

The compliance rate will be higher if the tax is _____ to understand.

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Answer

simple

Show question

Question

Give an example of a trade-off between equity and convenience?

Show answer

Answer

Having multiple income tax brackets may improve equity. However, the convenience may decrease compared to a flat tax rate.

Show question

Question

Give an example of a tax altering incentives of businesses?

Show answer

Answer

As businesses are responsible for withholding income taxes on behalf of their employees, income tax brackets may alter their incentives to gradually increase workers' salaries. Instead, they may wait to postpone salary increases until it becomes substantial or worthwhile.

Show question

Question

Give an example of a tax altering incentives of individuals?

Show answer

Answer

If businesses react by postponing salary increases, this would also alter the workers' behavior. Knowing that they won't receive their salary increase any time soon, they may get disincentivized to work to their fullest potential and shirk instead. This may also affect workers' certainty about their future income and their intertemporal consumption smoothing. They may increase their preference for higher savings now, which can discourage economic growth in the short run.

Show question

Question

Give an example of a trade-off between equity and efficiency?

Show answer

Answer

Income tax is a progressive tax, which results in greater equity. However, the tax brackets can negatively impact individuals whose income fluctuates.

Show question

Question

Give an example of a trade-off between flexibility and fairness?

Show answer

Answer

Suppose firms would find it easier to substitute workers for capital. In that case, they can pay the workers less and therefore pay less in payroll taxes to the government.

Show question

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