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TAXATION PRINCIPLES:

Taxes are the mandatory payments made by members of society to governments to finance government operations. The study of public finance identifies several key principles of taxation -- tax effects (revenue and allocation), tax proportionality (proportional, progressive, and regressive), tax payments (benefit and ability-to-pay), tax equity (horizontal and vertical).
A number of important taxation principles arise in the study of public finance. These principles provide insight into causes and consequences of government taxation. At the top of the list is the reasons or justifications for collecting taxes from members of society. The two key reasons are termed the revenue effect (generating revenue to financed government activities) and the allocation effect (using taxes to discourage particular production, consumption, or exchange activities).

Another important set of principles deals with the proportionality of taxes with respect to income, that is, what proportion of income is paid in taxes at different incomes levels. The three alternatives are proportional (equal proportion at every income level), progressive (a higher proportion of income at higher incomes), and regressive (a higher proportion of income at lower incomes).

Public finance is further concerned with the equity and "fairness" of who pays taxes and who should pay taxes. This leads to two noted principles -- the benefit principle (those who benefit from a good pay the taxes) and the ability-to-pay principle (those who have the income pay the taxes). When applying the ability-to-pay principle to types of equity warrant further concern -- horizontal equity (equal incomes pay equal taxes) and vertical (higher incomes pay higher taxes).

Tax Effects

Governments first and foremost impose taxes as a means of generating revenue, what is termed the revenue effect. However, they also recognize that taxes can be used to alter the allocation of resources, what is termed the allocation effect.
  • Revenue Effect: The primary reason governments impose taxes is to generate the revenue used to finance the operation of government, most notably the provision of public goods. Governments need access to resources to build highways, defend the nation, educate the population, and maintain the legal system. They purchase these resources with tax revenue.

  • Allocation Effect: A second reason governments impose taxes is to change the allocation of resources. Because people would rather not pay taxes, taxes create disincentives to produce, consume, and exchange. If society deems that less of a particular good, such as alcohol, pollution, or cigarettes are "bad," then a tax can reduce its production and consumption, and thus change the allocation of resources.
While governments might impose taxes for one reason or the other, all taxes have both effects. A tax intended to generate revenue changes the allocation of resources. A tax intended to change the allocation of resources generates revenue. However, different taxes achieve the two effects to different degrees. Ideally, governments want revenue generated by taxes with little allocation effect. And when governments impose taxes to discourage a particular activity, success entails little revenue effect.

Tax Proportionality

While governments have levied taxes on a wide range of goods, services, and activities over the centuries, all taxes are ultimately paid from income. Tax proportionality is the proportion of income paid in taxes at different levels of income. In some cases the proportion of income paid in taxes increases with income and in other cases it decreases. And in still other cases, it remains the same. This suggests three alternatives.
  • Proportional: A proportional tax is one in which the proportion of income paid in taxes is the same for all income levels. A proportional income tax exists, for example, if ever taxpayer pays exactly 20% of their income in taxes, that is, the same tax rate.

  • Progressive: A progressive tax is one in which the proportion of income paid in taxes is greater for higher income levels. A progressive income tax exists, for example, if taxpayers with more income pay a 25% of their income in taxes, while those with less income pay 20%.

  • Regressive: A regressive tax is one in which the proportion of income paid in taxes is smaller for higher income levels. A regressive income tax exists, for example, if taxpayers with more income pay a 15% of their income in taxes, while those with less income pay 20%.
Different taxes have different degrees of tax proportionality. Some are progressive. Some are regressive. Very few actually end up exactly proportional. Sales taxes tend to be regressive, while estate taxes are progressive. Personal income taxes are designed to be progressive, and are at lower to moderate income levels, but tend to be regressive at higher income levels.

Tax Equity

As the ones setting and enforcing the rules, governments have a great deal of power to impose taxes. They often temper this authority (or at least should) with some notion of the fairness with which taxes are imposed. Two particular notions of fairness are the benefit principle and the ability-to-pay principle.
  • Benefit Principle: The benefit principle states that taxes should be based on the benefits received, that is, those who receive the greatest benefits should pay the most taxes. On the surface, this principle is quite logical and easily justified. The people who benefit from public goods are logically the ones who should pay for their provision. Drivers should pay for highways, library patrons should pay for libraries, students should pay tuition, camping enthusiasts should pay for national parks, and the list goes on.

    However, the benefit principle does not work well for the efficient provision of public (and near-public) goods. Due to nonrival consumption, such goods are efficiently allocated with a zero price. If those who benefit directly from a public or near-public good pay a price equal to the value derived, as would be the case for private goods, then the "quantity demanded" declines and so too does the overall level of benefit generated. This is not efficient.

  • Ability-to-Pay Principle: An alternative criterion is the ability-to-pay principle, which states that taxes should be based on the ability to pay taxes, that is, those who have more income should pay more taxes. This principle also makes a great deal of sense, especially for the provision of public goods that are consumed by all. If everyone benefits from public goods, without exclusion, then everyone should pay. However, not everyone CAN pay, so those who CAN afford to pay, need to bear the burden.

    Because taxes are a means of transferring the purchasing power of income to governments, the ability to pay is based on income. Those who have more income can afford to pay more taxes, that is, they have a greater ability to pay.
The ability-to-pay principle gives rise to two additional notions of fairness. It seems "fair" and equitable that those with the same ability to pay should pay the same taxes and those with different abilities should pay different taxes. More specifically this is termed horizontal equity and vertical equity.
  • Horizontal Equity: This tax equity principle states that people with the same ability to pay taxes should pay the same amount of taxes. If two people each earn $50,000 of income, and one pays $5,000 income taxes, a rate of 10%, then horizontal equity means the other should pay the same $5,000 and 10%.

  • Vertical Equity: This tax equity principle states that people with a different ability to pay taxes should pay a different amount of taxes. If one person earns $50,000 of income and pays $5,000 income taxes, a rate of 10%, then vertical equity means another person who earns less, say $5,000 of income, should pay fewer taxes, say $500.

<= TAXATION BASICSTAXES =>


Recommended Citation:

TAXATION PRINCIPLES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: November 27, 2014].


Check Out These Related Terms...

     | taxation basics | tax effects | revenue effect | allocation effect | tax equity | ability-to-pay principle | benefit principle | horizontal equity | vertical equity | tax proportionality | proportional tax | progressive tax | regressive tax | tax efficiency | tax incidence | tax wedge | deadweight loss |


Or For A Little Background...

     | taxes | government functions | efficiency | equity | distribution standards | public finance | allocation |


And For Further Study...

     | public choice | good types | market failures | public goods: demand | public goods: efficiency | tax multiplier | personal tax and nontax payments | transfer payments |


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