What is Tax?

 

A tax is a compulsory financial charge or some other type of levy imposed upon a taxpayer (an legal entity or individual) by a governmental organization in order to fund various public expenditures. A failure to pay, along with evasion of or resistance to taxation, is punishable by law. Taxes consist of direct or indirect taxes and may be paid in money or as its labour equivalent. The first known taxation took place in Ancient Egypt around 3000–2800 BC.

Most countries have a tax system in place to pay for public, common or agreed national needs and government functions. Some levy a flat percentage rate of taxation on personal annual income, but most scale taxes based on annual income amounts. Most countries charge a tax on an individual’s income as well as on corporate income. Countries or subunits often also impose wealth taxes, inheritance taxes, estate taxes, gift taxes, property taxes, sales taxes, payroll taxes or tariffs.

In economic terms, taxation transfers wealth from households or businesses to the government. This has effects which can both increase and reduce economic growth and economic welfare. Consequently, taxation is a highly debated topic.

The legal definition, and the economic definition of taxes differ in some ways such as economists do not regard many transfers to governments as taxes. For example, some transfers to the public sector are comparable to prices. Examples include, tuition at public universities, and fees for utilities provided by local governments. Governments also obtain resources by “creating” money and coins (for example, by printing bills and by minting coins), through voluntary gifts (for example, contributions to public universities and museums), by imposing penalties (such as traffic fines), by borrowing, and also by confiscating wealth. From the view of economists, a tax is a non-penal, yet compulsory transfer of resources from the private to the public sector, levied on a basis of predetermined criteria and without reference to specific benefit received.

In modern taxation systems, governments levy taxes in money; but in-kind and corvée taxation are characteristic of traditional or pre-capitalist states and their functional equivalents. The method of taxation and the government expenditure of taxes raised is often highly debated in politics and economics. Tax collection is performed by a government agency such as the Ghana Revenue Authority, Canada Revenue Agency, the Internal Revenue Service (IRS) in the United States, Her Majesty’s Revenue and Customs (HMRC) in the United Kingdom or Federal Tax Service in Russia. When taxes are not fully paid, the state may impose civil penalties (such as fines or forfeiture) or criminal penalties (such as incarceration) on the non-paying entity or individual.

Purposes and effects

The levying of taxes aims to raise revenue to fund governing or to alter prices in order to affect demand. States and their functional equivalents throughout history have used money provided by taxation to carry out many functions. Some of these include expenditures on economic infrastructure (roads, public transportation, sanitation, legal systems, public safety, education, health-care systems), military, scientific research, culture and the arts, public works, distribution, data collection and dissemination, public insurance, and the operation of government itself. A government’s ability to raise taxes is called its fiscal capacity.

When expenditures exceed tax revenue, a government accumulates debt. A portion of taxes may be used to service past debts. Governments also use taxes to fund welfare and public services. These services can include education systems, pensions for the elderly, unemployment benefits, and public transportation. Energy, water and waste management systems are also common public utilities.

According to the proponents of the chartalist theory of money creation, taxes are not needed for government revenue, as long as the government in question is able to issue fiat money. According to this view, the purpose of taxation is to maintain the stability of the currency, express public policy regarding the distribution of wealth, subsidizing certain industries or population groups or isolating the costs of certain benefits, such as highways or social security.

Effects can be divided in two fundamental categories:

  • Taxes cause an income effectbecause they reduce purchasing power to taxpayers.
  • Taxes cause a substitution effectwhen taxation causes a substitution between taxed goods and untaxed goods.

Substitution effect and income effect with a taxation on y good.

If we consider, for instance, two normal goods, x and y, whose prices are respectively px and py and an individual budget constraint given by the equation xpx + ypy = Y, where Y is the income, the slope of the budget constraint, in a graph where is represented good x on the vertical axis and good y on the horizontal axes, is equal to –py/px . The initial equilibrium is in the point (C), in which budget constraint and indifference curve are tangent, introducing an ad valorem tax on the y good (budget constraint: pxx + py(1 + τ)y = Y) , the budget constraint’s slope becomes equal to –py(1 + τ)/px. The new equilibrium is now in the tangent point (A) with a lower indifferent curve.

As can be noticed the tax’s introduction causes two consequences:

  1. It changes the consumers’ real income (less purchasing power)
  2. It raises the relative price of y

The income effect shows the variation of y good quantity given by the change of real income.The substitution effect shows the variation of y good determined by relative prices’ variation. This kind of taxation (that causes substitution effect) can be considered distortionary.

Budget’s constraint shift after an introduction of a lump sum tax or a general tax on consumption or a proportional income tax.

Another example can be the Introduction of an income lump-sum tax (xpx + ypy = Y – T), with a parallel shift downward of the budget constraint, can be produced a higher revenue with the same loss of consumers’ utility compared with the property tax case, from another point of view, the same revenue can be produced with a lower utility sacrifice. The lower utility (with the same revenue) or the lower revenue (with the same utility) given by a distortionary tax are called excess pressure. The same result, reached with an income lump-sum tax, can be obtained with these following types of taxes (all of them cause only a budget constraint’s shift without causing a substitution effect), the budget constraint’s slope remains the same (-px/py):

  • A general tax on consumption: (Budget constraint: px(1 + τ)xpy(1 + τ)y = Y)
  • A proportional income tax: (Budget constraint: xpxypy = Y(1 – t))

When the t and τ rates are chosen respecting this equation (where t is the rate of income tax and tau is the consumption tax’s rate):

{\displaystyle {\frac {1}{1+\tau }}=1-t\Rightarrow t={\frac {\tau }{1+\tau }}}

The effects of the two taxes are the same.

A tax effectively changes relative prices of products. Therefore, most economists, especially neoclassical economists, argue that taxation creates market distortion and results in economic inefficiency unless there are (positive or negative) externalities associated with the activities that are taxed that need to be internalized to reach an efficient market outcome. They have therefore sought to identify the kind of tax system that would minimize this distortion. Recent scholarship suggests that in the United States of America, the federal government effectively taxes investments in higher education more heavily than it subsidizes higher education, thereby contributing to a shortage of skilled workers and unusually high differences in pre-tax earnings between highly educated and less-educated workers.

Taxes can even have effects on labour supply: we can consider a model in which the consumer chooses the number of hours spent working and the amount spent on consumption. Let us suppose that only one good exists and no income is saved.

Consumers have a given number of hours (H) that is divided between work (L) and free time (F = H – L). The hourly wage is called w and it tells us the free time’s opportunity cost, i.e. the income to which the individual renounces consuming an additional hour of free time. Consumption and hours of work have a positive relationship, more hours of work mean more earnings and, assuming that workers don’t save money, more earnings imply an increase in consumption (Y = C = wL). Free time and consumption can be considered as two normal goods (workers have to decide between working one hour more, that would mean consuming more, or having one more hour of free time) and the budget constraint is negative inclined (Y = w(H – F)). The indifference curve related to these two goods has a negative slope and free time becomes more and more important with high levels of consumption. It’s because a high level of consumption means that people are already spending many hours working, so, in this situation, they need more free time than consume and it implies that they have to be paid with a higher salary to work an additional hour. A proportional income tax, changing budget constraint’s slope (now Y = w(1 – t)(H – F)), implies both substitution and income effects. The problem now is that the two effects go in opposite ways: income effect tells us that, with an income tax, the consumer feels poorer and for this reason he wants to work more, causing an increase in labour offer. On the other hand, substitution effect tells us that free time, being a normal good, is now more convenient compared to consume and it implies a decrease in labour offer. Therefore, the total effect can be both an increase or a decrease of labour offer, depending on indifference curve’s shape.

The Laffer curve. In this case, the critical point is at a tax rate of 70%. Revenue increases until this peak, then it starts decreasing.

The Laffer curve depicts the amount of government revenue as a function of the rate of taxation. It shows that for a tax rate above a certain critical rate, government revenue starts decreasing as the tax rate rises, as a consequence of a decline in labour supply. This theory supports that, if the tax rate is above that critical point, a decrease in the tax rate should imply a rise in labour supply that in turn would lead to an increase in government revenue.

Governments use different kinds of taxes and vary the tax rates. They do this in order to distribute the tax burden among individuals or classes of the population involved in taxable activities, such as the business sector, or to redistribute resources between individuals or classes in the population. Historically, taxes on the poor supported the nobility; modern social-security systems aim to support the poor, the disabled, or the retired by taxes on those who are still working. In addition, taxes are applied to fund foreign aid and military ventures, to influence the macroeconomic performance of the economy (a government’s strategy for doing this is called its fiscal policy; see also tax exemption), or to modify patterns of consumption or employment within an economy, by making some classes of transaction more or less attractive.

A state’s tax system often reflects its communal values and the values of those in current political power. To create a system of taxation, a state must make choices regarding the distribution of the tax burden—who will pay taxes and how much they will pay—and how the taxes collected will be spent. In democratic nations where the public elects those in charge of establishing or administering the tax system, these choices reflect the type of community that the public wishes to create. In countries where the public does not have a significant amount of influence over the system of taxation, that system may reflect more closely the values of those in power.

All large businesses incur administrative costs in the process of delivering revenue collected from customers to the suppliers of the goods or services being purchased. Taxation is no different; the resource collected from the public through taxation is always greater than the amount which can be used by the government. The difference is called the compliance cost and includes (for example) the labour cost and other expenses incurred in complying with tax laws and rules. The collection of a tax in order to spend it on a specified purpose, for example collecting a tax on alcohol to pay directly for alcoholism-rehabilitation centres, is called hypothecation. Finance ministers often dislike this practice, since it reduces their freedom of action. Some economic theorists regard hypothecation as intellectually dishonest since, in reality, money is fungible. Furthermore, it often happens that taxes or excises initially levied to fund some specific government programs are then later diverted to the government general fund. In some cases, such taxes are collected in fundamentally inefficient ways, for example, though highway tolls.

Since governments also resolve commercial disputes, especially in countries with common law, similar arguments are sometimes used to justify a sales tax or value added tax. Some (libertarians, for example) portray most or all forms of taxes as immoral due to their involuntary (and therefore eventually coercive or violent) nature. The most extreme anti-tax view, anarcho-capitalism, holds that all social services should be voluntarily bought by the people using them.

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