Taxes will have significant effects upon the economic behavior of individuals and functioning of the economy as a whole. This fact must be well considered in designing and execution of the tax structure and policies in a way so that there will be positive or desirable effects, and avoid undesirable or adverse behaviors in achieving the economic goals of the society. And also, the burden of taxes must be distributed among the people in a manner consistent with these goals. The goals accepted for optimum level of economic welfare in a liberal society are:
- Maximum freedom of choice consistent with the freedom of others
- Optimum level of living standard in terms of available resources and technology in consistent with the consumer and factor owner’s preferences and
- Distribution of income in conformity with the standards of equity currently accepted by the society.
Principles of taxation refer to the appropriate criterion for designing and executing the tax structure and policies. Adam Smith was the first writer to prescribe the principles of taxation in the form of canons of taxation. Later writers added some more canons. The canons of taxation are basically accepted as the general guiding principles of over-all tax system.
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The four canons of taxation advocated by Adam Smith were:
1. Equity: The burden of taxes should be distributed among the people in an equitable way. “The subjects of every state ought to contribute towards the support of the governments nearly as possible in proportion to their respective abilities, that is in proportion to the revenue they enjoy under the protection of the state”.
2. Certainty: The amount, time and mode (procedure) of tax payment should be certain.
3. Convenience: The time and mode of tax payment should be convenient to the taxpayers.
4. Economy: The cost of collection of taxes should be minimized as far as possible.
Later other writers like Bastable added other canons beside that of Adam Smith. They are:
5. Productivity: The tax system should be able to yield enough revenue so that government may not be forced to resort deficit financing, and also promote productivity of the economy.
6. Flexibility: The tax structure needs to be revised as per the need of the economy and the treasury.
7. Simplicity: All provisions and terms related with tax system must be clear and simple so that even a common man can understand, and not have ambiguities.
8. Diversity: It is necessary to have a wide range of taxes to avoid the chances of possible ill-effects some taxes as well as to generate maximum potential revenue.
Besides these canons, principle of taxation is mainly concerned with the distribution of the burden of tax on people (taxpayers) in an equitable way as accepted by the consensus of the society. Equity in the tax system refers to horizontal and vertical equity. The horizontal equity refers to equal treatment to the equals. The vertical equity refers to relative or discriminatory treatment to the unequals, There are two principles of taxation to maintain equity in taxation. They are the Benefit-received and Ability-to- pay principles.
Benefit-received Principle
The principle accepts benefit-received as justification for taxation as well as a standard for apportioning the tax burden among the people. The principle emphasizes on ‘quid-pro-quo’ term in the relationship between people and the state. The obligation to pay and the amount to pay are individualized like in case of market system. Government services (mainly protection) provide certain benefits to the community. The cost of providing the benefits should be apportioned among the individuals and organizations on the basis of relative benefits they enjoy under the protection of the state. The principle has two approaches in determining tax amount on the taxpayers. The first is the cost of service which refers to the cost to provide benefit one enjoys. The second is the value of service, which refers to the value of benefit one enjoys from the government services.
This principle has its foundation on the Social-contract Theory of State up to the mid 18th. Century. Contract was the basis of the formation of the organized society in the form of the state, mainly for protection. Then, taxes were considered as the price for protection services.
Sir William Petty, in late 17th. Century, argued that all men should contribute to the public charge according to the share and interest they have in public peace revealed by their estates and riches. Similarly, Adam Smith argued that citizen should contribute to support the government, as nearly as possible, in proportion to their respective abilities that is in proportion to the revenue they enjoy under the protection of the state.
In late 19th. Century, this principle was considered as an approach for efficient allocation of resources. Since tax impositions for public services involve withdrawal of resources from private sector, tax and expenditure should be joint to maintain general equilibrium.
Writers like Mazzola and De Marco advocated distribution of tax burden on the basis of marginal utility or benefit an individual get from the government services. So they argued different prices / tax for government services for different persons according to respective marginal benefit they enjoy.
Strength of the Principle
- The principle is based on the assumption that benefit from government services justifies tax imposition.
- Since the principle considers both the income and expenditure of government, and so determine the size of government expenditure and tax shares on it at the time, making government cautious in maintaining fiscal balance as far as possible.
- The principle is practically applied in cases where benefit from government services can be individualized, and is in practice in the form of fees or charges.
Weaknesses or Limitations of the Principle
- Contribution to the government services on the basis of benefit is actually not a tax, rather it is like a price.
- In general cases, benefit from government services cannot be individualized.
- The principle does not incorporate the modern role of taxes in maintaining economic stability, promotion of economic growth and distributive justice.
- It is questionable to assume the income received by individuals is only because of the benefit from government services.
- It doesn’t incorporate the externalities of some public goods.
Ability-to- pay Principle
The term ability refers to the economic well-being or over-all standards of living enjoyed by the people. This principle is based on the logic that a person is to pay tax because he can. In other words, it is his duty to pay tax to support the government according to his relative ability. The principle accepts obligation to support the government as a social or collective responsibility. It does not accept the existence of the exchange relationship between the state and taxpayers.
According to this principle, equity in taxation requires that persons with the equal ability are to pay tax at equal rate and amount. Whereas, persons with greater ability are to pay tax at higher rate and amount. And persons, who have no ability need not pay. This principle is based on the assumption that the Law of diminishing marginal utility applies also in case of money or income, and also interpersonal comparison of utility is possible.
It is said that, even though this principle is older than the benefit-received principle, J.S.Mill, in early 19th. Century, was the leading person to advocate this principle strongly. His statement in this concern was, “The equality of taxation means equality of sacrifice. It means apportioning the contribution of each person towards the expense of government in a way so that he will feel neither more nor less inconvenience from his share of payment than every other person experiences from his.” So, in his opinion, taxation will be just and equitable only when the distribution of tax burden will be in such a way so that all the taxpayers incur equal sacrifice.
The concept of equal sacrifice has been interpreted in three ways. Equal Absolute Sacrifice refers that the total loss of utility (sacrifice) as a result of tax should be equal for all tax payers. Equal Proportional Sacrifice refers to the loss of utility as a result of tax should be proportional the economic status of the taxpayers. Equal Marginal Sacrifice refers to the marginal sacrifice by all the tax payers should be the same. This is also called the least aggregate sacrifice.
Index of Ability-to-Pay
The subjective criteria of sacrifice approach in determining and apportioning the tax burden is difficult to apply in practice. So, the supporters of this principle have developed the objective indices or criterion for assessing one's ability for practical application of this principle. There are three indices to measure ones ability or economic well-being.
- Property or Accumulated wealth: Prior to the industrial revolution and development of monetization, property or accumulated wealth was considered the best index of ability. Wealth was accepted as the better index than the income because wealth is not only the source of income but also an indicator of one's social status, power and economic security. Property reflects additional source of income. It is also accepted that the inherited property has a higher ability to pay tax than that from personal efforts. However, with the progress of industrial society and development of monetization, there has been a shift from property to income as the best index of ability.
- Income: Income is universally accepted as the best index of one’s ability. Musgrave emphasized that the relative welfare position on individuals should be measured in terms of their income, and sacrifice is a function of income surrendered for taxation. A family’s well being depends mainly on the income received in a specific time period. Generally, the net income after making allowances to maintain a family in a way as socially accepted is considered as an ability from the taxation point of view. The Classical writers defined taxable income as the clear income, which they meant the income above subsistence level. They advocated complete exemption of tax on low and middle income people and imposition of taxes on higher income people in a proportional rate. And also, imposition of higher rate on unearned income than the earned income, was suggested.
- Consumption expenditure: The pattern of consumption expenditure reflects one’s tax paying ability. So, taxes on consumption expenditure emphasized that the taxable capacity should be defined as the share of one’s consumption out of the national production.
All these indices, taken individually as the only index of ability do not cover all the potential sources of taxation. So, in modern times, all these indices are accepted as the indices of ability.
Strengths of the Principle
- This principle is justified on three grounds. The first is the ability as the basis of taxation and is quite justifiable.
- The second is the equality in sacrifice by all taxpayers which is also quite justifiable.
- Thirdly, the principle is justified as an approach for promoting distributive justice in the society.
Weaknesses or Limitations of the Principle
Critics of this principle opined that the assumption of application of the Law of Diminishing Marginal Utility on income and wealth, and inter-personal comparison of utility is quite subjective, and is difficult in practice.
Application of this principle may cause disincentive to work, save and invest, and may have negative effects on the economy.
But these criticisms cannot be accepted in modern welfare-state thinking.
