What is Tax?
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer by a governmental organization to fund government spending and various public expenditures. A failure to pay, along with evasion of or resistance to taxation, is punishable by law.
Tax is an imposition of compulsory levies on individuals or entities by governments. Taxes are levied in almost every country of the world, primarily to raise revenue for government expenditures, although they serve other purposes.
Canons of taxation
The ‘canons of taxation were set of criteria to judge taxes. They are still widely accepted as providing a good basis to judge taxes. Four canons tax were:
- The cost of the collection must be low relative to the yield
- The timing and amount to be paid must be certain to the payer
- The means and timing of payment must be convenient to the payer
- Tax should be levied according to the ability to pay
Modern economists have added three more canons to these to update and extend them:
- A tax must not hinder efficiency or should involve the least loss of efficiency
- A tax should be compatible with foreign tax systems
- Tax should automatically adjust to changes in the rate of inflation (particularly important in high inflation economies)
A good tax should meet most of these criteria, and these canons are well worth learning to judge how good a tax is.
Types of Tax
- Direct taxation – This is taxation on income. It covers taxes like income tax, profits tax, and wealth taxes on inheritance.
- Indirect taxation – This is taxation on expenditure. It covers taxes like VAT, excise duties tax on cigarettes, and alcohol.
Progressive, regressive, and proportional taxes
Taxes differ according to their impact on different income groups. Some taxes will redistribute from better-off groups to less well-off, called progressive taxes. However, others will have the opposite effect, and these are called regressive taxes. The definitions that you need to know are:
- Progressive tax – This tax takes a greater proportion of a person’s income as their income rises.
- The regressive – tax takes a smaller proportion of a person’s income as their income rises.
- Proportional tax – a tax where the percentage of income paid in taxation always stays the same.
The balance of these taxes can significantly affect income distribution in an economy. If a government chooses to switch the balance of taxation from progressive to regressive taxes, society’s less well-off will be the hardest hit. In general, direct taxes tend to be progressive and indirect taxes regressive.
Taxation and public expenditure as a policy tool
Taxation and public expenditure are crucial tools in the government’s economic armory. The use of them to manage the economy is known as fiscal policy, and it centers on:
- They are raising or lowering taxation – either direct or indirect forms.
- Changing the levels and pattern of public expenditure – may be in investment (new schools, hospitals, etc.) or transfer payments (benefits, pensions, and tax credits).
- Budget strategy – to plan for a surplus or deficit, the government is often forced to borrow during a downturn in the economy or balance borrowing over the economic cycle. What is balanced during a slowdown is paid back when the economy enters growth again. A ‘golden rule’ may also be applied to ensure that any government borrowing is only used for investment spending and not for current spending (on wages etc.).
Why does a government tax? Well, it does not have any money of its own! It takes some from those who can, in theory, afford it and re-directs this to the more vulnerable members of society. Hence, direct taxes, and in particular income tax, are normally progressive. This means that the richer community members contribute more to help the less well-off.