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Ability-to-Pay Principle of Taxation

Dr. Ikramul Haq[i]

It states that if a given amount of revenue is needed to finance public services, then each taxpayer should contribute in line with his ability-to-pay taxes. Those who possess more economic power (income and wealth) should contribute more to public exchequer and vice versa. The duty to pay taxes is seen as a collective responsibility rather than a personal one. The ability-to-pay principle views tax policy issues in isolation to incidence of public expenditure. This principle is regarded by many as the most equitable and just method of taxation. It is emphasized primarily for its redistributive role.

For implementing the ability-to-pay rule, it is necessary to know as to how this ability is to be measured. Should ability-to-pay of an individual be identified with his income, net wealth, family size, health status of family members or some combination of these and other factors? And if a combination is to be considered, how to decide the relative weightage to be assigned to each of the various factors? Formidable problems arise when two individuals with equal incomes but unequal wealth or equal wealth but unequal incomes are considered. More serious problems arise when individuals A and B have unequal incomes and unequal wealth in such a way that A has more income than B and B has more wealth than A. How is the inequality of income to be adjusted against the inequality of property? In short, the question I show should people with differing abilities be treated for the purpose of taxation? Unfortunately, such questions cannot be answered objectively.

Though not perfect, the index of taxable capacity is commonly interpreted in terms of a taxpayer’s income with his wealth acting as a supplementary factor.

Granted that ability-t-pay is to be measured in terms of income, it is simple that taxpayers with equal incomes should pay the same amount of tax. This is called horizontal equity, i.e. taxpayers in similar economic circumstances should bear the same tax burden, economic circumstances being defined in terms of level of income. The second aspect of ability-t-pay rule is vertical equity, i.e. taxpayers in dissimilar economic circumstances should bear dissimilar tax burdens. Thus, persons earning more should pay more tax than those, earning less. Obviously, formidable problems arise when taxpayers with different income levels are considered and decisions are required as to how the tax system should deal with these differences. In other words, how far the taxes on people with different incomes should differ to ensure vertical equity?

Both the aspects of ability-t-pay rule are based on the philosophy that tax burden on individuals should be so distributed as to force them to make ‘ equal sacrifice’, being defined as loss of utility or satisfaction by surrendering units of money as tax.

The equal sacrifice rule, associated with such distinguished economists as J.S. Mill and A.C. Pigou, is based on the following assumptions. 1. It is possible to relate units of income with units of utility. 2. The utility curve for income has a downward slope, i.e. marginal utility of income varies inversely with income. 3. The marginal utility of income curve is the same for all individuals.

Under these assumptions, the equal sacrifice rule is clear for taxpayers with equal incomes. They should surrender equal amounts as tax which in turn means sacrificing equal units of utility (horizontal equity). However, difficulties arise in interpreting equal sacrifice rule for people with different incomes. How is the term ‘equal’ to be understood? In the tax literature the following three interpretations of the equal sacrifice rule are found.

  1. Equal Absolute Sacrifice.  It means the number of units of utility taken away from each taxpayer should be exactly the same.
  2. Equal Marginal Sacrifice.  The marginal sacrifice is the same, i.e. utility left with, rather than taken from, every taxpayer after tax should be the same. This will ensure minimum total sacrifice for society, and hence it is also called Least Aggregate Sacrifice Principle.

Equal sacrifice theory is based on vague assumptions. Utility, being a psychological phenomenon, is not only non-measurable for any one individual but also non-comparable as between individuals. In short, determination of a tax base capable of measuring an individual’s ability-t-pay is a major problem of tax theory. Yet this rule is incorporated in the form of progressive rate schedule for personal income tax, estate duty, and property tax worldwide. See also Benefit Principle of Taxation.

Assessment Year See Previous Year Versus Assessment Year

Assignment of Tax

Assignment of a tax means transfer of taxation power form a higher level to a lower level government. Taxation power includes the following: right to levy the tax, collect the tax, and appropriate the proceeds from the tax. Thus, there can be three interpretations of assignment of a tax. Firstly, higher-level government may levy and collect a tax but handover the entire proceeds to lower level governments. Taxes (e.g. estate duty) levied by the Government of India under Article 269 of the Constitution are a case in point. Secondly, the higher-level government may levy a tax but allow the lower level governments to collect is and retain fully the proceeds therefrom. Taxes (e.g. stamp duties) levied by the Government of India under Article 268 of the constitution fall under this category. Finally, the higher level government may transfer a tax to lower level governments lock stock and barrel, a situation which defines assignment of a tax in its strictest sense.

Generally, the purpose of tax assignment is to augment the resources of lower level governments. The assignment of tax may be conditional. Thus, it may be obligatory on the part of a lower level government to levy the tax assigned to it. Not only this, the lower level government may not have powers to alter the basic structure of the assigned tax. It may enjoy flexibility in fixing the tax rates within a minimum and maximum rage prescribed by the higher-level government.

Benefit Principle of Taxation

According to this traditional approach, an equitable tax system is one under which tax payments are based on the amount of benefits received from government services. In other words, the cost of government services should be apportioned among individuals according to the relative benefits they enjoy. Clearly, implementation of the benefit principle presupposes determination of the incidence of public expenditure before deciding distribution of tax burden. Thus it encompasses issues of both tax and expenditure policies.

Two objections are generally raised against the benefit principle of taxation, one on grounds of practicability and the other on considerations of desirability. As already noted, for implementing the benefit principle, the beneficiaries of public expenditure must be identified. This may be possible in the case of highway tolls, fishing and hunting licences, and property taxes. However, it is very difficult to allocate costs or benefits of the majority of government services among citizens. Who benefits from defence services, maintenance of foreign relations, space technology, or contributions to U.N.O.? Costs of these services cannot be divided and assigned logically to the recipients of the benefits. Most services of modern governments are provided in the interest of group rather than individual welfare. These difficulties limit the practicability of the benefit theory.

Even if it is possible to identify persons or classes receiving direct benefit from government services, it may not be desirable to tax them accordingly. This is particularly so in underdeveloped countries where tax policy is used as a tool of distributive justice. Governments in these countries have launched ambitious programmes, financed mainly through taxes, to solve the twin problems of unemployment and poverty. These welfare-oriented schemes include subsidized/free medical and educational facilities, low-cost housing, drinking water facilities in rural areas, land improvement schemes, and employment guarantee programmes. The beneficiaries of these schemes are not expected to compensate the government for the benefits received. Similarly, certain transfer payments (like scholarships to needy students or outright money grants to widows or handicapped) are financed from taxes and it would be ridiculous to expect the beneficiaries to contribute to public exchequer in line with the benefits received.

In short, tax policy is also an instrument of social change and not merely a charge for the services rendered by public bodies. The redistributive role of tax policy cannot be realized through benefit approach which is based on the implicit assumption of equitable distribution of economic power. Hence, the application of benefit theory of taxation is not widespread in the modern world. See also Ability-t-Pay Principle of Taxation.

Buoyancy and Elasticity of Tax Revenue

These terms refer to the degree of responsiveness of tax yield to changes in national income.

Tax revenue may change through automatic response of the tax yield to changes in national income and/ or through the imposition of new taxes, revision of the bases and/or the rates of the existing taxes, tax amnesties, stricter tax compliance and other administrative measures backed by legal action. Changes in the tax yield resulting from modifying tax parameters (bases, rates etc.) are called discretionary changes. Variations in the tax yield flowing from the combined effects of automatic responses as well as discretionary changes constitute the buoyancy of a tax. It is computed by dividing percentage change in tax yield by percentage change in national income.

With tax parameters held constant (i.e. discretionary changes being removed), automatic changes in the tax yield resulting from variations in the national income measure the elasticity of a tax system. It is the ratio of percentage change in tax revenue (adjusted for discretionary changes) to percentage change in national income.

With tax parameters held constant (i.e. discretionary changes being removed), automatic changes in the tax yield resulting from variations in the national income measure the elasticity of a tax system. It is the ratio of percentage change in tax revenue (adjusted for discretionary changes) to percentage change in national income.

Buoyancy estimates assess the overall success of government measures to increase tax revenues while elasticity coefficients indicate the inherent responsiveness of a tax system to changes in national income. In the absence or weakness of elasticity attribute of the tax system, a government will have to revise tax rates and tax bases every year to keep the share of tax revenue in national income undiminished. Such frequent changes complicate tax laws, reduce administrative efficiency and are also politically inexpedient. Therefore, tax structure should be so designed as to impart reasonable degree of elasticity to the tax system.

Objectives of Tax Policy

Taxation is a potent instrument to shape and influence the socioeconomic polices of a country. It is, of course, difficult to formulate a set of universally acceptable goals of tax policy because (a) different countries are in different stages of economic development, (b) objectives of economic policy differ in these countries, (c) priorities of economic policy continually change with the changing economic, social, and political milieu.

Though the concept of an ideal tax system for a country is linked with the peculiar characteristics of its economy, tax policy is usually assigned the following four functions in the stated order in a typical developing economy: resource mobilisation, resource allocation, distributive justice, and stabilization.

  1. Resource Mobilisation. The first and foremost objective of tax policy in a country is to raise resources for public authorities for administration and development. Taxes are the main instrument for transferring resources from private to public use. By designing an appropriate tax structure, resources can be raised from those who are holding them idly or squandering them on luxury consumption. According to Roy Gobin, “ the revenue criterion is usually the dominant consideration, since governments in LDCs have become increasingly aware of the active role which budgetary measures can play not only in initiating and promoting growth but also in maintaining political power. Not only are higher revenue levels needed, but also tax yields should be increased at a faster rate than income, if infrastructural investments and social welfare expenditures are to be financed without generating unacceptable inflationary pressures and/or increasing reliance on foreign assistance.”

The revenue performance, i.e. resources in developing countries calls for their optimum utilization. Since the composition of investment is an important determinant of growth rate of the economy, public policy must discourage the flow of resources to low priority areas so that they could be diverted to vital sectors of the economy. By imposing high tax rates on luxuries and other low priority items (such as motor cars, air conditioners, and jeweler), the government can discourage the consumption and production of such items, ensuring in the process release of resources for high priority sectors. Conversely, production of necessities of life and employment-oriented industries can be encouraged by offering tax concessions or even subsidies.

  • Distributive Justice. Distributive justice or economic justice is an important function of tax policy. Economic justice relates largely to distribution of tax burden and benefits of public expenditure. It is a component of the broader concept of social justice, which encompasses, besides distributive justice, such questions as treatment of women and children, and racial and religious tolerance in a society. Tax policy is a democratic method to influence the distribution of income and wealth on desired lines. The main ingredients of this policy can be (a) progressive direct taxation of income, wealth, and property transactions, (b) taxation of commodities (customs duty, excise levy, and sales tax) purchased largely by high-income groups, and (c) subsidies (negative taxation) on goods purchased by low-income groups.

Highlighting the importance of taxation and public expenditure policies in the context of redistribution of economic power, Alejandro Foxley has opined, “ modern public finance studies have de-emphasized the analysis of the normative considerations of theory and focused on the very basic question of incidence: who pays and who benefits from government action? Thus we can say that focus has shifted from question of what should the State do? To the question of knowing what in fact is has been doing?”

  • Stabilisation.  Initial developmental efforts are generally marked by inflationary tendencies in an economy. Inflation, if uncontrolled, may thwart all development plans and bring misery to the poor. A reasonable degree of price stability should be a primary concern of a government’s economic policies.

The overall level of economic activity in an economy depends upon aggregate demand, relative to capacity output. At times, the level of aggregate demand may be insufficient to secure full employment of labor and other factors of production. At other times, aggregate demand may exceed available output at full employment level. Government intervention in both the cases becomes essential to correct such disequilibria in the economy.

Monetary and fiscal policies are important instruments available to the government to ensure smooth functioning of the economy. Reduction in taxes during deflation would leave greater disposable incomes with the people, giving a boost to aggregate demand. The reverse is true in times of inflation.

The evaluation of a tax system with reference to the foregoing objectives in a difficult task because various other policies (like public expenditure policy) may be geared to achieve the same objectives. To what extent the redistributive objective has been served and what was the relative role of tax policy in it is a difficult question to answer. Moreover, the various objectives of tax policy may not always work harmoniously. Rather, they are often in conflict with each other if not mutually exclusive. Since the tax system of a country grows out of the interaction between political judgment and economic rationale, the process of compromises and trade offs is influenced by political expediency and economic logic, the former, in most cases, having the upper hand. In fact, political requirements and economic thinking change with time, giving new directions to tax policy. As Richard Bird has observed, “ Tax reform is, therefore, a never-ending process, not something that can be brought about once and for all and then forgotten.”

Operating Costs of a Tax See Compliance Costs of a Tax

Optimal Taxation

It advocates a system of taxation, which generates the least loss of welfare. Optimal taxation involves a variety of questions like the ration between direct and indirect taxes, progressivity of taxes, trade off between equity and efficiency and other related issues.

Classical System of Company Taxation See Corporate Income Tax

Classification of Taxes

There are several ways of classifying taxes. The Organisaiton for Economic Co-operation and Development (OECD) has classified taxes in a straightforward and business-like manner. Though this classification ignores economic nature of different taxes, it has proved very useful for inter-country tax comparisons. OECD classification groups different taxes into categories and sub-categories like taxes on goods and services, taxes on income, profits, and capital gains, taxes on net wealth and immovable property, taxes and stamp duties on gifts, inheritances etc. The following OECD classification of taxes is descriptive rather than prescriptive.

OECD Classification of Taxes

1000 Taxes on income, profits and capital gains

1100 Taxes on income, profits and capital gains of individuals

1200 Corporate taxes on income, profits and capital gains

2000 Social security contributions

2100 Employees

2200 Employers

2300 Self-employed or non-employed

3000 Taxes on payroll and workforce

4000 Taxes on property

4100 Recurrent taxes on immovable property

4200 Recurrent taxes on net wealth

4300 Estate, inheritance and gift taxes

4400 Taxes on financial and capital transactions

5000 Taxes on goods and services

5100 Taxes on production and sale of goods and renderings of services

5200 Taxes on use of goods

6000 Other taxes

6100 Paid solely by business

6200 Paid by other than business

Compliance Costs of a Tax

Compliance costs refer to costs incurred by taxpayers or third parties in complying with a tax, over and above the tax payment made to public authorities. The third party compliance costs are those incurred by firms in discharging their legal responsibility as tax collectors, e.g. deducting income tax from salaries and passing it on to the tax authorities.

Three types of compliance costs may be distinguished: (a) Money costs like payment for legal advise, fees to accountants or to valuers for valuation of property (for purposes of death duties, wealth tax etc.), cost of postage, telephone calls, traveling, books, and in some cases litigation. (b)Time costs include time taken to consult tax advisers, complete tax returns, and to travel to tax offices. (c) Psychic costs are the worries and anxieties associated with tax payment.

Administrative costs plus compliance costs make up the total operating costs of a tax.

Issues in Corporate Income Tax.   Various questions arise regarding the tax treatment of corporation profits.

1.   Should corporations are taxed at all on their profits? A tax on the profits of corporations is a common feature of industrial societies. Absence of corporation tax would encourage business firms to form corporate entities to avoid personal income tax by retention of profits.

2.   Should corporation tax discriminate between retained and distributed profits? Under one scheme known as split rate method; distributed profits may be taxed at a lower rate than retained profits. However, such distinction causes complexity in tax laws. Therefore, corporation profits are generally taxed without making a distinction between retained and distributed profits

  • There is a view that corporation profits should be distributed among the shareholders and then taxed at the shareholders’ level (under the individual income tax) instead of at the corporation level. The taxes due to shareholders on dividends may be withheld at the corporation level to be credited subsequently under the individual income tax. In practice, most countries tax corporation income separately resulting in Double Taxation (q.v.) of corporate earnings. Tax laws often contain provisions to mitigate this kind of tax duplication.

Interaction Between Corporate and Individual Income Tax

Corporation tax is related with individual income tax in, at least, three ways.

  1. Under the classical system (as prevalent in the United States), a corporation is viewed as a separate entity distinct from its shareholders and therefore taxed in its own capacity. The liability of a corporation is divorced entirely from that of the shareholders so that dividends are taxed twice, first as income of the corporation, and subsequently as income of the shareholders.
  • Under the full integration system (or full dividend imputation system), a corporation is not seen as a separate entity from its shareholders. The corporation tax is treated as a withholding tax, which is credited in full to shareholders. This credit is used against personal income tax, which is die on their imputed share of corporation profits.

Under the partial imputation system, a shareholder is given credit against some part of his own personal tax liability. Australia introduced a system from July 1, 1987 under which Franked Dividends (q.v) paid out of income already subject to corporation tax carry a credit to individual shareholders. Originally, the system represented a full integration of the corporation and personal tax regimes because corporation tax rate were same (47 percent) and therefore no personal tax was ever payable on franked dividends. However, following a reduction in the rate of corporation tax to 39 per cent, a taxpayer subject to the top personal rate of 47 per cent is now subject to additional tax on dividends. Hence, the integration is partial instead of full as was the case initially.

3.   Then, there is the split rate system, which lies between the above tow extremes. Under it, relief is provided through a lower tax rate on corporate distributions than on retained profits.

Cost- Yield Ratio

It is the cost of collection expressed as a proportion of tax revenue. A lower cost-yield ratio is considered indicative of the efficiency of tax administration. Unusually high cost-yield ratio is a drag on the public exchequer. Thus, cost-yield ratios may be used to evaluate administration of competing taxes.

The concept of cost-yield ration suffers from various limitations and therefore needs to be used carefully as an index of tax efficiency. The ratio depends upon the nature of a tax. Generally, cost of collecting direct taxes is high as compared to indirect taxes. The ratio is also affected by the nature of tax administration. If separate administration is used for each tax, the scope of scale economies is greatly reduced. Conversely, if a single administration deals with a variety of taxes of similar nature (e.g. all direct taxes), cost-yield ratio may fall due to scale economies.

Cost-yield ratio is also influenced by the nature of an economy. The ratio is generally high in developing countries, which are in the process of evolving their tax systems. Widespread illiteracy and lack of accounting practices make assessment procedures extremely difficult in these countries.

Pointing out another limitation, G.K. Saw has observed, “ The cost-yield ration provides a purely static insight into the efficiency of a given tax which may be misleading in terms of the potential dynamic evolution of the tax. Thus, for example, a tax in its infancy may have high costs associated with the establishment of the appropriate administration and collection machinery and yet its future prognosis may be favourable if it is progressively based or confronts income elastic demand conditions.”

It is noteworthy that reduction in cost of collection, which leads to ineffective enforcement and hence tax evasion, is false economy. Similarly, employment to of incompetent and/or inadequate staff can result in harassment of taxpayers and multiplying appeals and hence increased cost of compliance. Properly understood, the principle of economy requires lowest possible costs consistent with effective administration and existing level of facilities to taxpayers. While interpreting cost-yield ratio, account should also be taken of compliance costs, which may differ from tax to tax.

Deficit Financing

Deficit financing is a kind of forced saving. When all types of government receipts fall short of its stipulated total expenditure, then the only alternative left with it is to print more currency. The net effect of deficit financing is to increase money supply in the economy. When money supply increases, it puts pressure on the supply of goods and services. Since supply cannot be increased so easily, prices have a tendency to rise. Price rise is accompanied by its own adverse effects because the burden of price rise falls inequitably on different classes. Deficit financing is a kind of inflation tax, which drives the people into involuntary savings.

Magnitude, timing, and consequences of deficit financing gare subjects of controversy among economists. In developing countries, government is always on the lookout for more and more resources to finance development schemes. Taxes are by far the most important source of public revenue but a great part of this revenue goes to meet the administrative expenditure of governments. Next in importance are borrowings, internal as well as external. When this source is also exhausted, then a government resorts to deficit financing gin order to claim a part of real resources of the economy.

Deficit financing is mainly resorted to during wartime or for development schemes. Apparently, if it is for the latter purpose, the ill effects would be short-lived because as the development schemes mature, the improved production level will reduce inflationary pressure in the economy. Contrarily, if it is for war purpose, the adverse consequences are long-drawn, causing widespread dislocation in the economy.

In the initial stages of development, a modest dose of deficit financing may be justified on the grounds of monetisation of the economy. When developmental activities pick up, the demand for money also increases because of increasing transactions. A controlled and gradual increase in money supply plays an important role by boosting investment in the economy. However, a reckless monetary expansion may prove dangerous by aggravating inflationary tendencies. In a supply-constrained economy, the Keynesian investment income multiplier operates more in money terms than in real terms. During inflation, fixed income groups are adversely affected and the poor suffer the most. Producers, distributors, speculators, and hoarders are the gainers. In extreme cases, if inflation becomes uncontrolled, people may lose faith in the currency itself. Thus, no society can afford a continuous and significant rise in the general price level. It is rightly said that deficit financing, like fire, is a good servant but a bad master.

Degressive Tax    

A progressive tax, which increases at a decreasing rate. A degressive tax is progressive because the tax rate increases as the size of the tax base increases but for each additional increase in the size of the base, the increase in tax rate is lower. In practice, most personal income tax schedules are degressive, because rising rates under them apply to wider and wider income brackets until all income above a certain amount is taxed at a proportional rate.

Earmarking of Taxes

Earmarking is a fiscal practice under which revenues from one or more sources are pooled into a separate independent fund, which is used to finance certain pre-determined public services.

The purpose of earmarking is to ensure stable funding for important public activities. Another objective of earmarking is to introduce market prices into the budgetary process. In this sense, earmarked taxes become indirect form of market prices charged for public services rendered.

Among the conditions for successful earmarking, the following are more important. 1. There should be a clear-cut linkage between the tax levied and the benefit received. 2. Expenditure is well defined so that the taxpayers can identify its obvious benefits. 3. Linkage between earmarked revenue (e.g. from motor vehicle tax) and predetermined expenditure (e.g. on construction and maintenance of municipal roads and bridges) is tight. 4. Revenue is in the for of direct user charger/benefit tax (e.g. a toll).

Traditionally, financing of road expenditure from out of tools, motor vehicle taxes, and fuel taxes has been considered an area with a strong economic rationale for earmarking. Similarly, airport tax is generally levied to meet expenditure on airport maintenance. The principle of earmarking could be applied to such municipal services as water supply, and sewage disposal by linking them to water and sewer charges which, in many cases, are components of the property tax in the sense that the base for these charges is the same as used for property (e.g. annual rental value). The principle of earmarking should not be applied indiscriminately because too many funds created under it would be difficult to on control.

Earned versus Unearned Income

Earned income (or employment or labour income) is derived from actual work or services performed and includes wages, salaries, and income from professions. Unearned income (or capital or property income) is derived from investment, rent etc.

Should tax laws distinguish between earned and unearned income in order to accord a favourable treatment to the former? Lenient treatment of earned income is justified on various grounds. Employment earnings represent returns on current efforts whereas capital income is often the result of inherited wealth, monopoly power, capital gains, gambling wins, and property received through gifts and marriages.

Earned income is more uncertain than investment income. A human being is a depreciating asset, which ceases to earn on retirement or death. Uncertainty of the human asset also arises from possible chances of suspension, dismissal, and premature retirement from service, illness, unemployment, and accident. Contrarily, physical and financial assets have a tendency to appreciate in value with the passage of time, particularly in a growing economy. Uncertainties associated with business income are less grievous and can be insured against by making gilt-edged investments.

Possession of property, besides being a source of monetary return, confers certain other benefits on the possessor, e.g. ability to dissave, security, and independence. It may also be argued that expenditure incurred in connection with earning income from employment (including expenses on education and training) is far more that that incurred in obtaining investment income. Therefore, it is unjust to treat the fruits of one’s own labour and windfall profits equally.

J.E. Meade Committee Report on The Structure and Reform of Direct Taxation advance the following four arguments as to why earned income should be treated ‘softly’ vis-à-vis other income for tax purposes. 1. Earned income is less permanent than investment income 2. Earned income involves a sacrifice of leisure, which is absent in the case of income from property, particularly from inherited property. 3. Earned income is the creation of a taxpayer’s own skill, ability, and effort while unearned income may accrue through the luck of inheritance. 4. Prestige, security, independence and influence, generally associated with the ownership of wealth, are absent in the case of earned income.

It is also well-known that labour earnings are recorded more systematically and in most cases tax is deducted at source, leaving no scope for malpractice in tax payment. As Vito Tanzi has observed, “ Income taxes on wages and salaries cannot be evaded, or at least it is much harder to do so, which provides a good ground for a lighter treatment of these incomes. In fact, if they are treated in the same way as other incomes, and if the assumption is true that taxes on them are difficult to evade, then a de jure non-discriminatory treatment of these incomes would amount to a de facto discrimination.”

It is not surprising that tax laws of many countries provide for relatively lenient tax treatment of earned income, e.g. earned income tax credit in the United States.

Some economists argue that the distinction between earned and unearned income is misleading because to the extent that property embodies past labour, the income from it is not ‘unearned’ and should not be taxed at a higher rate than earned income.

Effects of Taxes

Taxes affect economic behaviour of individuals and organizations in several ways. They affect our decisions regarding savings, investments, location of production centers, techniques of production, and above all consumption of different goods.

All taxes involve money burden on the people. Total yield of a tax to a government indicates total direct money burden on the citizens. Taxes also generate indirect money burden. For example, excise duty is collected by the government from the producer who in turn recovers it from the consumers. There is generally a time gap between the payment of excise by the producer and its subsequent recovery from the consumers. The lock up of money during this period devolves on the producer an indirect money burden, which is equal to the interest he could have earned on that money.

Similarly, a distinction is drawn between direct and indirect real burden of a tax. According to Hugh Dalton,” To part with a shilling in payment of a tax means a greater sacrifice of economic welfare for a poor man that for a rich man. But that is a question, not of the incidence, but the direct real burden of the tax. Again, when the price of sugar is raised by taxation, a family may have to eat less sugar, and so make a sacrifice of economic welfare. But that is a question, not of the incidence, but the indirect real burden of the tax.” By distorting consumption patterns, taxes may lead to inefficient use of resources. Taxes also affect the relative economic positions of individual sand households.

Efficiency in Taxation

In addition to the revenue actually raised, taxes impose a variety of other costs on the society efficiency in taxation requires minimization of these costs, which are generally grouped under the following three categories: 1. Excess Burden of Taxation (q.v.) 2. Administrative Costs (q.v.), and 3. Compliance Costs (q.v.).

Excess Burden of Taxation

Excess burden (or deadweight loss or efficiency cost) refers to the reduction in consumers’ welfare over and above their loss of income as a result of tax payment. It arises due to changes in the relative prices of taxed and untaxed commodities in the post-tax period. Distortions in consumers’ choices between goods or producers’ choices between factors, brought about by the imposition of taxes are burdensome to taxpayers without bringing any benefit to the government. Hence, they should be minimized. Economic efficiency is defined in terms of neutrality of taxation and aims at minimizing or eliminating deadweight loss.

When a tax is imposed, the spending power of a taxpayer is reduced. This is called the income effect of taxation and does not in itself result in economic inefficiency. However, when a tax affects relative prices, inducing individuals to substitute one commodity for another, it generates a substitution effect, which causes economic inefficiency by interfering with consumers’ choices. More the distortion, the greater is the excess burden and vice versa. In certain cases, distortion of consumption patterns may be desirable if the consumption of private goods involves social costs over and above the private costs. A tax on feeling of trees to preserve wildlife and environment is a case in point.

F.A. Ramsey first showed in 1927 that deadweight loss is minimized when a set of differential ad valorem rates is imposed such as to reduce the production of all commodities in equal proportion.

However, it is not easy to fix tax rates on different goods so that the demand for them is reduced proportionately. Since the (price) elasticity of demand for various goods is different, it would require different ax rates on these goods. In general, goods with relatively inelastic demand would have to be taxed at a higher rate than goods with relatively elastic demand. The practical problems of this approach are indeed grave.

Expenditure Tax

It is a tax on personal expenditure. The early proponents of expenditure tax include such celebrities as Leviathan Hobbes, John Stuart Mill, and Irving Fisher. In 1955, Nicholas Kaldor in his book An Expenditure Tax argued vigorously in favour of expenditure as a measure on an individual’s taxpaying capacity. In  1978, J.E. Meade Committee Report on The Structure and Regorm of Direct Taxation also argued for the superiority of expenditure tax over income tax while analyzing the possibilities and problems of expenditure tax in the United Kingdom. The list of opponents of expenditure tax is no less distinguished. It includes, among other, Richard Musgrave, Richard Goode, and Carl Shoup. These experts have expressed themselves against expenditure tax mainly on account of administrative and compliance problems.

The first argument in favour of expenditure tax rests on the ground that individuals should be taxed on what they take out from the national pool in terms of goods and services (consumption), rather than on what they contribute in terms of labour and capital services (income). This traditional argument has its origin in the following observation of Leviathan Hobbes, “ What reason is there, that he which laboureth much, and sparing the fruits of his labour, consumeth little, should be more charged, than he that liveth idlely getteth little, and spendeth all he gets: Seeing the one hath no more protection from the Commonwealth than the other.”

Two objections can be raised against Hobbes’s reasoning. 1. The income of an individual does not arise only through his work and capital services. It is also received through capital gains, monopoly power, gifts in marriage or otherwise, lottery prizes, and more commonly through inheritance. Defined comprehensively, income does not always refer to the ‘ contribution’ one can be said to have made to total output. 2. There is no apparent justification to regard a tax on expenditure (actual consumption) as more equitable than a tax on income (potential consumption). J.A. Kay and M.A. Kind in their book The British Tax System have opined, “ A one-legged unemployed man who manages to maintain a low level of consumption by begging is unlikely to be seen as just a suitable an object of taxation as wealthy miser who chooses to spend very little and counts his money each night.”

The second argument in favour of expenditure tax is its supposedly favourable effects on saving. Firstly, it encourages savings because the more one saves; the greater is the tax benefit. Secondly, it avoids “ double taxation of savings” as is allegedly the case under a system of income tax. Income tax is imposed on income when it is first received, and then on interest earned when the same income is saved. As against this, expenditure tax impinges on savings only once, i.e. when they are spent. In brief, and expenditure tax tends to induce savings because the more one saves the greater is the tax benefit.

The foregoing argument implicitly assumes that savings are a virtue for a country. This is not necessarily so. Increasing the rate of savings is by no means a high priority objective in developed countries some of which, in fact, face dangers of excessive savings. Furthermore, an increase in the amount that people wish to invest.

It at all savings are to be encouraged, it can be done by making special provisions in the tax laws. In fact, income tax laws in most countries accord favourable treatment to saving s not only by exempting them from taxation but also income arising out of them. These provisions can be further strengthened in case more savings are desired.

The law of marginal propensity to save states that with increasing income the propensity to save also increases. It follows that the rich who save more will be the major beneficiaries of expenditure tax. This may promote concentration of wealth in a few hands, leading to undesirable social and economic consequences.

Similarly, the ‘ double taxation of savings’ argument is untenable because by no standards interest earned on savings can be regarded as savings. In all fairness, interest earned does increase the ability-to-pay of an individual.

The third argument in favour of expenditure tax is that problem of averaging is less severe under it than under income tax. In their work already quoted, J.A. Kay and A.A. King maintain, “ Problems of averaging are likely to be less severe also, because whereas an individual has little control over the timing of receipts of windfall gains he can choose when to spend his resources. Moreover, it seems likely that individuals prefer to maintain a relatively stable pattern of expenditure over a run of years, and not to enjoy a burst of spending in one year followed by relative deprivation in succeeding years”.

The above reasoning is not necessarily correct. While it is true that fortunes in a speculative business are subject to fluctuations, people are fairly certain about their receipts from salaries, interest income, property income, gains of profession, and profits of less adventurous business. Conversely, unexpected expenditure to deal with sickness, accidents, and natural calamities is more serious a problem particularly in countries lacking social security arrangements. A proper perception of the expenditure pattern of families requires an understanding of the social and religious values of societies. For example, in many traditional societies it is quite common to spend one’s lifetime savings in celebrating marriages or performing religious rituals. The treatment of such lumpy expenditure will be a special problem in administering an expenditure tax. Its burden will be heavy in those years in which a family’s social and religious commitments are high compared to their income. In other words, bursts in spending are more grievous than fluctuations in income.

Administrative Problems

How is the annual expenditure of an individual to be computed? Administratively, expenditure tax is the most dreaded tax for fiscal authorities. The nightmare is partly the result of the nomenclature of the tax, which suggests, prima facie, as if administration will have to keep records of the details of each taxpayer’s expenditure. The expenditure tax argues that operation of an expenditure tax does not require an exhaustive listing of every purchase made during the tax year. In its simplest form the assessment of expenditure tax requires the assessment of a taxpayer’s income and his net savings during the year. Net savings are to be deducted from his income to arrive at his expenditure for the year

Expenditure= Income – Savings + Dissavings

Where

Savings      = Expenditure on assets + Money lent out + Repayment received.

Dissavings       = Sales of assets + Money borrowed + Repayments received.

Apparently, in any assessment of expenditure, the calculation of income is a prerequisite involving all problems of income assessment under the income tax system. Definition of income for purposes of calculating expenditure tax has to be broader from the one used for income tax purposes. It will include exempt receipts, gifts received etc. Similarly, net wealth would also have to include certain assets often excluded under wealth tax. A taxpayer will be obliged to periodically report information concerning the value of assets added to and withdrawn from savings. This would require a taxpayer to submit a statement of all assets and liabilities as at the end of the financial year. This statement would then be compared with the comparable statement submitted at the close of the preceding year so that correctness of reported additions to and withdrawals form net wealth could be ascertained.

Yet another administrative problem relates to the consumption of consumer durables. It would involve all problems of measuring depreciation of enduring assets. Similarly, there are goods and services, which are consumed, jointly by family members and it will be

A problem to allocate this collective consumption among different members of the family. In short, expenditure tax is the proverbial Pandora’s Box containing various conceptual and administrative difficulties the fear of which has greatly reduced the practicability of this tax.

Expenditure Tax in Practice.   Following the recommendations of Professor Nicholas Kaldor, a tax on personal expenditure was first imposed in India on April 1, 1958. The tax was introduced as an adjunct to the personal income tax as a part of a scheme to evolve a self-checking system of direct taxes in India.

Expenditure tax was withdrawn in 1962 on account of insignificant revenue yield and its failure to restrain ostentatious expenditure in order to promote savings. It was reintroduced in 1964 with the hope that the tax would help lessen inequalities of income and wealth. However, the tax was repealed again in 1966 on grounds of burden on administration and inconvenience to assesses.

Introduction of expenditure tax proved abortive in Ceylon (now Sri Lanka) also where it was imposed in 1959 but withdrawn in 1963. The unsuccessful experiments of India, and Sri Lanka have deterred other countries to impose expenditure tax.

It is noteworthy that Nicholas Kaldor’s proposal for expenditure tax in Britain in the early 1950s was turned down by the Chancellor of the Exchequer who termed it ‘ too radical’. Similarly, in the United States, when the tax was proposed by the Treasury in 1942 the reaction of the Congress was so hostile that the suggestion had to be withdrawn within a week.


[i] Dr. Ikramul Haq, a leading international tax counsel, is a well-known author specialising in international tax, press, intellectual property, corporate and constitutional law. Dr. Ikram is Chief Partner of Lahore Law Associates (fax: +92 42 7226953, e-mail: irm@brain.net.pk; website: http://www.paktax.com.pk). He is a member of the visiting faculty of the Institute of Direct Taxes in Lahore. He served for 12 years as Deputy Commissioner of Income Tax. He studied literature, journalism and law, for his Masters and Doctorate degrees. He has written many books on various aspects of Pakistani law and global narcotics trade, some of which are co-authored with his wife, Mrs. Huzaima Bukhari, Additional Commissioner of Income Tax. He has been awarded Doctorate of Law for his research: Tax Reform in Quasi-Constitutional Perspective.

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