Taxation

I

Introduction

Taxation, system of compulsory contributions levied by a government or other qualified public body on people, corporations, and property, in order to fund public expenditure. In deciding whom, what, and how much to tax, all governments have economic and social objectives. Some types of business activity or product, such as cigarettes, may be discouraged by heavy taxes. Other businesses, such as those operating in depressed areas, may be encouraged by tax breaks. Or taxation may be used to bring about social reforms through altering the distribution of wealth.

The effectiveness of any government, at central or local level, depends on the willingness of the people governed to surrender or exchange a measure of control over property in return for protection and other services. Taxation is one form of this exchange.

II

Historical Differences

In medieval times, taxes were customarily paid not in money but in the form of labour or other payments in kind (such as work on local roads or supplies of grain or other farm produce). As long as the government’s services consisted largely of military actions and the provision of roads and other public works, this form of taxation satisfied most governmental needs reasonably well. Rulers could require feudal lords to provide, as a form of tax, workers or soldiers in numbers that reflected the noble’s rank and wealth. In the same manner, grain levies could be imposed on landowners, both to feed the workers or troops and to provide for other government needs. In modern industrial nations, although taxes are levied in terms of money, the fundamental pattern remains: the government designates a tax base (such as income, property holdings, or a given commodity); applies a tax-rate structure to the base; and collects the tax (equal to the base multiplied by the applicable rate) from the stipulated legal taxpayer.

Tax systems, even today, are as varied as the nations that devise them, ranging in complexity from the most basic arrangements to computerized revenue systems. Simple tax mechanisms are suitable only to the needs of those governments that are extremely limited in scope. When government responsibilities are extensive and diverse (as, for example, when taxes are used to modify economic inequalities and to distribute benefits in ways that are considered equitable), the underlying system of taxes must be sophisticated. Elaborate networks of fiscal reporting become essential, as do legal enforcement and a standard of public education adequate to ensure a high degree of taxpayer compliance.

III

Principles of Taxation

Tax systems perform differing functions, depending on the responsibilities expected of the enacting government. Local governments traditionally depend most heavily on property taxes, and central governments on sales taxes and income taxes. Local governments are required to keep their expenditures within the budgetary limits, determined by their own revenues augmented by payments received from central government, though in some circumstances they can borrow money. The central government, however, can borrow or even create money; it does not have to raise enough from its tax system to balance its budget. Taxation is also the basic instrument of fiscal policy. In concert with its control over the money supply (that is, its monetary policy), the government aims to maintain the stability of the economy. In depressions, for example, taxes may be lowered and budget deficits incurred so that consumers will have money to buy goods and investors will have capital to put into industry, thus stimulating production. In prosperous times, tax increases may be needed to hold down or prevent the inflation caused by too much money chasing too few goods, or if the government prefers to control inflation through interest rates, taxes may be cut for political or other ends.

Among the tax systems of different nations, wide variations exist in how money is raised and spent. Tax and expenditure policies reveal the fundamental ideology of a government and a political system. Most democracies today derive their general notions of what constitutes a good tax system from four principles enunciated in the 18th century by the Scottish economist Adam Smith.

A

Fairness

Of fundamental importance is that any tax must be fair—that is, citizens should be taxed in proportion to their abilities to pay (a concept that Smith defined somewhat ambiguously as “in proportion to the benefit they derive from the government”). A tax is considered fair if those who have the means to pay are assessed either in proportion to their capacity to pay or, depending on the situation, in proportion to what they receive from the government. Both “ability to pay” and “benefits received”, therefore, are criteria of fairness. When government services confer identifiable personal benefits on some individuals and not on others, and when it is feasible to expect the users to bear a reasonable part of the cost, financing the benefits, at least partly, by taxing the people who benefit is considered fair, as in the repayment of loans to students by subsequent taxation. (Obviously, this method does not apply to such services as public welfare payments.) Taxation in accordance with appropriately applied standards of ability to pay or of benefits received is said to meet the requirements of vertical equity (because such taxation exacts different amounts from people in different situations). Just as important is horizontal equity—the principle that people who are equally able to pay and who benefit equally should be taxed equally.