Taxation

IV

PRINCIPLES OF TAXATION

Seventeenth-century French statesman Jean-Baptiste Colbert declared, “The art of taxation is the art of plucking the goose so as to get the largest possible amount of feathers with the least possible squealing.” Today’s economists have rather different ideas of what constitutes a good tax system. Most believe that a tax system should follow two main principles: fairness and efficiency. Scottish economist Adam Smith laid out these principles in his landmark treatise The Wealth of Nations (1776). See the Sidebar “From The Wealth of Nations.”

A

Fairness

Economists consider two principles of fairness to determine whether the burden of a tax is distributed fairly: the ability-to-pay principle and the benefits principle.

A

1

Ability-to-Pay Principle

The ability-to-pay principle holds that people’s taxes should be based upon their ability to pay, usually as measured by income or wealth. One implication of this principle is horizontal equity, which states that people in equal positions should pay the same amount of tax. If two people both have incomes of $50,000, then horizontal equity requires that they pay the same amount of tax. Suppose, however, that two individuals both have incomes of $50,000, but one has a lot of medical bills and the other is healthy. Are they in equal positions? If not, then perhaps the tax burden of the person with medical bills should be reduced. But by how much? And how does a person document to tax authorities that he or she is truly paying medical costs, and not just pretending in order to lower the tax bill? This example illustrates a fundamental dilemma in tax design: Fairness is often the enemy of simplicity.

A second requirement of the ability-to-pay principle is vertical equity, the idea that a tax system should distribute the burden fairly across people with different abilities to pay. This idea implies that a person with higher income should pay more in taxes than one with less income. But how much more? Should families with different incomes be taxed at the same rate or at different rates? Taxes may be proportional, progressive, or regressive. A proportional tax takes the same percentage of income from all people. A progressive tax takes a higher percentage of income as income rises—rich people not only pay a larger amount of money than poor people, but a larger fraction of their incomes. A regressive tax takes a smaller percentage of income as income rises—poor people pay a larger fraction of their incomes in taxes than rich people.

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Which is fairest—a proportional, progressive, or regressive system? There is no scientific way to resolve this question. The answer depends on ethical and philosophical judgments, such as whether a society has the right to take income from one group of people and give it to another. A progressive, proportional, or even slightly regressive system all can achieve vertical equity’s requirement that a richer person should pay more in taxes than a poorer person. Most industrialized nations have progressive income tax systems, which impose a heavier tax burden as one’s income increases. In the United States, the individual income tax system divides taxable income into different tax brackets—ranges of income with different tax rates.

Some economists consider sales taxes regressive because individuals with higher incomes spend a smaller proportion of their incomes on sales taxes than those with lower incomes. A poor person and a rich person who spend the same amount on groceries each year will pay the same amount in sales taxes, even though the rich person earns more money. However, rich people consume more than poor people, and studies of people’s spending patterns reveal that, over the course of a lifetime, the rich person will pay roughly the same proportion of his or her income in sales taxes as the poor person.

A

2

Benefits Principle

The benefits principle of taxation states that only the beneficiaries of a particular government program should have to pay for it. The benefits principle regards public services as similar to private goods and regards taxes as the price people must pay for these services. The practical application of the benefits principle is extremely limited, because most government services are consumed by the community as a whole. For example, one cannot estimate the benefit received by a particular individual for general public services such as national defense and local police protection.

One can make a case that, for some taxes, there is a relationship between taxes paid and benefits received. Gasoline taxes, for example, are used to finance highway construction. But even here, the link between taxes and benefits is weak. Some drivers have more fuel-efficient cars than others. They may use the roads as much as other drivers, but buy less gasoline and thus pay less tax. Merchants who operate stores along the sides of highways benefit from the presence of the roads, but the benefit has nothing to do with the merchants’ gasoline consumption. Despite its intuitive appeal, the benefits principle is not important in practice, and it plays little role in the design of tax systems.

B

Efficiency

In addition to being fair, a good tax system should be efficient, wasting as little money and resources as possible. Three measures of efficiency are administration costs, compliance costs, and excess burden.

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