- 1 Definition
- 2 Distinction between taxes and fees
- 3 Classification of taxes
- 4 Costs and benefits of taxation
- 5 Implementation of taxation
- 6 Tax revenue
- 7 Ethics of taxation
A tax is a mandatory payment that needs to be made to a government or regulatory body, which typically varies in quantity based on some other quantity of money involved that is being taxed.
Distinction between taxes and fees
The term tax and fee are sometimes used interchangeably, but there are usually some key differences:
- A fee is typically levied in exchange for some service rendered, and the quantity of the fee is dependent on the nature and extent of the service. Taxes, on the other hand, are not levied in exchange for any direct services rendered. Although taxpayers collectively do get some services, the receipt of the service is not conditional on or directly related to the payment of taxes.
- Fees can be levied by governmental and private bodies. Taxes are usually levied by governments.
- With fees, it is usually possible to opt out of the service and not have to pay the fee. With taxes, it is not usually possible or easy to opt out by refusing to accept all the services that taxation pays for.
Private bodies that provide services invariably have to rely on fees. Governmental bodies can rely both on taxes and fees. For instance, a municipal authority that maintains the water supply to a city can fund it through fees levied on all buildings that tap into the water supply, or fund it out of general tax revenue collected from the city, or a combination of the two.
In some cases, the line between taxes and fees is murky. For instance, gasoline taxes in the United States were used to fund the interstate highway system between 1950 and 2000. Gasoline taxes fit the definition of tax rather than fee, but assuming a reasonable correlation between gasoline consumption and highway use, they play a role similar to fees.
Classification of taxes
Classification based on nature of quantity being taxed
|income tax||tax on individuals and households based on the income earned.|
|capital gains tax||a form/variation of the income tax that taxes the gains made on assets owned (such as land, capital, shares in companies)|
|consumption tax: sales tax and value-added tax||tax on consumption or purchase of items. The sales tax is a point-of-sale tax imposed at the final sale to the consumer, while the value-added tax is a tax imposed on the value added at every step of the production process.|
|corporate tax||tax on firms based on their net profits.|
|wealth tax||tax levied on the total wealth that an individual or household possesses. A special case is the estate tax, which is levied when an individual dies and part of the individual's estate is taken by the government, the rest being distributed according to that individual's will or to the individual's heirs.|
Classification based on nature of tax function
Most taxes are increasing (or at least non-decreasing) functions of the quantity being taxed.
The average tax rate for a given tax is the ratio of the quantity of the tax to the quantity being taxed, and the marginal tax rate is the rate of change in the quantity of the tax relative to the quantity being taxed. A tax is called a:
- Progressive tax if the marginal tax rate is an increasing (or non-decreasing) function of the quantity being taxed. The average tax rate in this case is also an increasing (or non-decreasing) function of the quantity being taxed.
- Flat tax if the marginal tax rate is constant, or equivalently, the average tax rate is constant.
- Regressive tax if the marginal tax rate is decreasing. Thus, the average tax rate is also decreasing.
Sometimes, the terms progressive and regressive are used more loosely for taxes based on disparate impact, i.e., a tax may be labeled progressive if it impacts rich people more than poor people (for instance, a high sales tax on yachts or private jets), and regressive if it impacts poor people more than rich people (for instance, a high sales tax on tobacco, which is used disproportionately by poor people). This is not a precise use of the terms progressive and regressive.
Classification based on purpose
Broadly speaking, there are three justifications for taxes:
- Revenue justification: To raise revenue for the taxing authority, which it may then use in a variety of ways, including:
- Provision of government services that have have some of the characteristics of public goods
- Redistributing to some of the poorest or worst-off people.
- Incentive justification: To encourage/discourage specific types of activities and/or raise money that can mitigate the effects of the activities being taxed. For instance, Pigovian taxes are levied to reflect external costs of activities to the participants. Similarly, sin taxes are meant to reduce incentives for people to perform activities that may be harmful to them.
- Group/class warfare justification: Taxes may be levied on people in certain groups in order to reduce the wealth of the people in these groups relative to others. Unpopular ethnic groups in democratic and dictatorial countries may suffer these problems. High taxes on the rich may also be levied in order to reduce their incomes and wealth and bring it down to that of other people. Taxes may be levied by politicians in power on those groups that oppose their rule. Conversely, tax breaks and tax credits may be given to popular groups or groups that enjoy a special connection with those in power.
In sanitized discussions of taxation, usually only the revenue and incentive justification are considered, although the group/class warfare justification may also play a key role.
Costs and benefits of taxation
We here focus on the social costs and social benefits of taxation. The simple fact that money is transferred from a taxpayer to the taxing authority does not itself indicate any net cost to society. Rather, the transaction costs and incentive effects need to be considered. Further, the overall cost-benefit analysis must consider all parties involved.
|Aspect of taxation||Is this a cost or benefit?||Explanation|
|Costs of compliance and oversight||Cost||Even in the simplest case where the tax laws are simple and everybody pays up their taxes, there is a cost of preparing tax returns, a cost of receiving and processing the tax returns, and a cost of the money transfers involved.|
|Less of the activity being taxed|| Usually a cost (if, in general, more of the activity is desired). In some cases, a benefit, if the activity being taxed is a bad.
The cost is often termed the deadweight loss due to taxation
| Generally, taxes on income and capital gains discourage work, saving, and investment, which, for the most part, are desirable.|
Taxes on consumption are somewhat more ambiguous. Usually, with the exception of taxes levied to compensate for external costs (called Pigovian taxes) and taxes levied to prevent long term bad consequences (such as sin taxes) such taxes are also considered bad. However, consumption taxes are generally considered less bad than income taxes since they encourage saving, so for a given amount of tax revenue that needs to be raised, a consumption tax is in most cases considered less distortionary.
|Costs of handling tax complexity, either through evasion or compliance||Cost||When the tax code becomes complex, individuals and firms may significantly distort their behavior in order to reduce their tax burden. These activities may either be harmful in themselves, or may divert resources from other socially useful activities.|
|More money for public goods||Benefit|| Some of the revenue collected through taxes is spent by governments on public goods -- goods that may be underprovided otherwise because of the free-rider problem. This is one of the principal justification of taxation and a justification for why some goods need to be funded by taxes rather than fees.|
It is important to note that the term public good does not just mean a good provided by a government, so a public good justification for taxation needs to be examined in its particulars.
|Money and in-kind help for some subgroups of the population||Ambiguous|| Taxes may fund a welfare state, bailouts, and other forms of government spending on particular groups. Prima facie, there is no reason why such a transfer of wealth should generate a net social benefit or cost.|
Arguments for the benefit typically rely on one or more of these: (i) the value of money is more for the recipients of welfare or bailouts than for net taxpayers, (ii) the government achieves some kind of efficiency in providing the services that wouldn't be possible through other means, or (iii) some form of an ethical argument such as equal opportunity or correcting past injustice. Conversely, arguments against such uses of taxes also hinge on questioning or reversing claims of the above sort, in addition to considering the distortion of incentives created by wealth transfers.
|People are required to report private data about their activities, earnings, etc. in their tax forms||Cost||The reporting requirements that accompany tax filing may lead to a loss of privacy, particularly if the tax collection agency does not take adequate precautions to maintain the confidentiality of tax documents filed.|
|More statistical information about the quantities being taxed||Benefit||Tax forms require individuals to report the quantities being taxed, and therefore, tax collection agencies are in a good position to generate, or cross-check, data on the totals and distributions of these quantities within the population being taxed.|
Implementation of taxation
One of the main challenges with taxation is the challenge of ensuring a high rate of tax compliance. Tax compliance refers to the extent to which people who are subject to the tax pay the amount of tax stipulated by the law. Tax evasion refers to the phenomenon of people avoiding payment of taxes, either by using legal loopholes or by failing to report the quantities being taxed.
To ensure a high rate of tax compliance, tax collection agencies usually come equipped with a variety of coercive powers to use against people whom they suspect of tax evasion, such as tax audits.
Revenue-maximizing tax rates
A taxing authority whose goal is to maximize tax revenue collected needs to choose a tax rate by considering a trade-off between two factors:
- The higher the tax rate, the larger the fraction of the quantity being taxed is collected as tax; however
- The higher the tax rate, the smaller the total quantity subject to taxation, because when you tax more of something, you get less of it. This effect may be seen with consumption taxes of luxury goods that are highly price sensitive, but it is also seen for income taxes and wealth taxes.
As a result, the tax revenue is not an everywhere increasing function of tax rates. Rather, it is generally expected to increase first and then decrease after some point. This idea was made popular by the Laffer curve, which plots total tax revenue as a function of tax rate.
Short run versus long run
The revenue-maximizing tax rate in the short run may differ from the revenue-maximizing tax rate in the long run. This is because of two reasons:
- In the long run, there is more scope for people to adjust away from the production or consumption activities that are subject to high taxation, or even to leave the high-tax jurisdiction. This reason generally supports the idea that the long run revenue-maximizing tax rate is lower than the short run revenue-maximizing tax rate.
- Also, revenue in the long run also depends on the overall condition of the economy, which in turn is influenced by tax rates. As noted, taxation generally discourages beneficial activities like work, saving, and investment. A higher tax rate, by discouraging such activities, may slow down economic growth slightly. In the long run, small differences in economic growth add up to considerable differences in economy size, and hence considerable differences in the potential for tax revenue.
Optimal tax rates need not be revenue-maximizing
The socially optimal tax rate need not be the revenue-maximizing tax rate. In the short run, the revenue-maximizing tax rate is the optimal tax rate for the taxing authority if its goal is to maximize revenue. Below are some kinds of trade-offs that governments need to consider:
- Dictators who don't expect to be around for long and don't care about their subjects, but want to make as much money as possible while still in office: Choose the short run revenue-maximizing tax rate.
- Dictators who expect to be around for long and don't care about their subjects, but want to make as much money as possible during their long reign: Choose the long run revenue-maximizing tax rate.
- Democratically elected leaders who need to face elections in a short period of time: Trade off between the benefits of greater tax revenues (which can then be spent on buying support or implementing popular programs) against the cost to approval ratings from high tax rates.
Generally speaking, the optimal tax rate should not be more than the revenue-maximizing tax rate, but it may well be less. There are two kinds of exceptions: exceptions where the goal of taxation is not revenue but discouraging specific activities, and exceptions where some democratically elected politicians are playing to popular dislike of specific groups (the rich, ethnic minorities, foreigners, etc.) by taxing them punitively. In practice, rationally self-interested politicians are likely to endorse high taxes on unpopular groups in rhetoric but not implement them in practice, and/or offer loopholes.
Ethics of taxation
Ethics of taxation in principle
- One extreme is to view taxation as a violation of the self-ownership principle or of property rights. Taxation here is viewed as being similar to slavery, servitude, conscription, or confiscation of one's property, albeit not necessarily as bad as these.
- A middle position is to view taxation as a necessary evil to fund certain necessary government programs (provision of public goods, maintenance of a safety net, etc. -- what government programs qualify as necessary is itself moot), but with the view that if it were possible for these programs to not be necessary, or to be funded in other ways, then taxation would indeed be immoral.
- The other extreme is to view taxation as desirable in and of itself, either as a glue that holds society together, or as a means of ensuring democratic accountability, or as a mechanism to bring about equal opportunity.
Ethics of the implementation of taxation
Given the reality of tax evasion and the challenges of tax compliance, taxation is accompanied both by reporting requirements and by coercive powers vested in the tax collection agency. These can pose threats to the liberties and privacy of individuals who are rightly or wrongly suspected of tax evasion. It may also be possible for tax collection agencies to misuse their authority by ordering tax audits, or leaking confidential reported tax information, for disliked groups and individuals.