Tax Policy Issues: Standards for a Good Tax

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Tax Policy Issues Standards for a Good Tax
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The art of taxation consists in so plucking the
goose as to obtain the largest possible amount of
feathers with the least possible amount of
hissing.Jean Baptiste Colbert
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Tax Policy Issues

• Standards for a Good Tax
• In theory every tax can and should be evaluated
  on a set of basic standards. In general a tax
  should be
• Sufficient to raise necessary government revenues
• Convenient to administer and to pay
• Efficient in economic terms
• Fair to taxpayers required to pay

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Tax Policy Issues - Sufficiency

• A Sufficient Tax
• A tax is sufficient if
• it generates enough funds to pay for the public
  goods and services provided by the government
  levying the tax.
• Forecasting revenue
• Static forecast - assume base stays the same.
• Dynamic forecast - estimate change in base due to
  change in rate.

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Tax Policy Issues - Sufficiency

• Income versus Substitution Effects
• Taxpayers modify their behavior in reaction to
  increased tax rates. These behavioral changes
  result in either a income effect or substitution
  effect.
• Income Effect
• Tax increase gt base increase / Tax decrease gt
  base decrease
• Work to keep after-tax income the same.
• Substitution Effect
• Tax increase gt base decrease / Tax decrease gt
  base increase
• Substitute between labor and leisure.
• Theoretically, the income effect is more powerful
  for lower-income taxpayers and the substitution
  effect is more compelling to higher-income
  taxpayers.

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Tax Policy Issues - Convenience

• A Convenient Tax
• A tax is convenient if
• Governments View
• the tax is easy to administer, easy to
  understand, and offers few opportunities for
  noncompliance.
• Taxpayers View
• the tax is easy to pay, easy to determine, and
  requires minimal time to comply.

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Tax Policy Issues - Efficiency

• A tax is efficient if
• judged by the classical standard of efficiency,
  it does not distort the market, create suboptimal
  allocation of goods and services, or modify
  taxpayer behavior.
• judged by Keynesian standards it is an effective
  fiscal policy tool for regulating the economy.

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Tax Policy Issues - Equity

• A tax is fair if
• the taxpayer has the Ability to Pay the tax.
• it enhances Horizontal Equity
• persons with the same ability to pay the tax
  should owe the same amount of tax.
• it enhances Vertical Equity
• persons with greater ability to pay owe more than
  persons with a lesser ability to pay.

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Tax Policy Issues - Equity

• Horizontal Equity
• Achieving horizontal equity depends heavily on
  the tax base definition.
• Tax loopholes vary across taxpayers.
• A simple but unpopular solution is to eliminate
  all tax preferences. This solution would likely
  increase the current systems horizontal equity
  but at the expense of the economic or social
  benefits derived from income producing activities
  that tax preferences are designed to promote.
  Examples?

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Tax Policy Issues

• Vertical Equity
• What should rate structure look like?
• The ongoing policy issue is usually not whether
  rich should pay more taxes than poor, but how
  much more is appropriate. The definition of how
  much more is, may result in a tax rate
  structure that is regressive, proportional, or
  progressive.

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Tax Policy Issues - Equity

• Regressive tax rate decreases as tax base
  increases.
• Smith pays 2,000 tax (10) on income of 20,000
  and Jones pays 3000 tax (5) on income of
  60,000.
• Proportional flat tax rate
• Smith pays 2000 tax (10) on income of 20,000,
  and Jones pays 6000 tax (10) on income of
  60,000.
• Progressive tax rate increases as tax base
  increases.
• Smith pays 2000 tax (10) on income of 20,000,
  but Jones pays 12,000 (20) on income of 60,000.

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Tax Policy Issues

• Tax Rate Structure
• Average Tax Rate total tax paid by tax base
  (typically gross income or taxable income)
• Marginal Tax Rate The rate of tax applied to
  the next dollar of taxable income. In a
  progressive rate structure this rate increases as
  income levels increase. In a proportionate rate
  structure average and marginal rates are the same.