The Four Main Desirable Characteristics Of Taxation Systems

Will start off with explanations of the different desirable characteristics. Then will go on to say how the UK income tax system fulfils these characteristics. Examples and sources would be used to backup the points made. At the end a conclusion will be drawn based upon how well UK tax system meets the desirable characteristics

Part (B)

Three taxes will be explained which are Progressive, regressive and proportional taxes are important to understand in order to assess whether the tax is fair or unfair income. And I will point out Currently UK Income tax which is a best example.

Part (A)

The four main desirable characteristics of taxation system were first introduced by the economist Adam Smith, who concentrated on how to design an effective tax system. In his book Wealth of Nations published in 1776, he described four desirable characteristics (Equity, Certainty, Convenience and Efficiency) for a tax system.

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Equity; determines that tax that should be fair, it ought to consider at all times taxpayers’ ‘ability to pay’, and therefore considering the impact it has on them. Equity considers the two approaches of ability to pay and the benefit principle. The horizontal equity and vertical equity measures the fairness of tax system. Horizontal equity is when taxpayers with equal taxable capacity bear the same tax burden. Vertical equity verifies that those whose need is greater suffer less tax. Vertical equity is difficult to achieve in practice but is suitable in theory. There are at least three layers associated with this problem. The first decision needs to be who in principle, should pay tax at higher rates to implement a tax system with vertical equity. Then a decision needs to be made on how much higher that rate should be compared to the rate paid by other taxpayers and finally to achieve the objectives for the variety of full tax payers, a tax system should be developed.

Certainty; emphasizes a taxpayer should not be able to avoid tax. The timing, method and amount due must be completely clear; therefore people can understand it in order to calculate his/her liability. It is preferred in situations where taxes are clear than where there is disagreement and uncertainty regarding the final tax payer and where to pay. For example corporation tax is a poor tax because it is unknown who (shareholders/consumers/others) should pay the tax. This characteristic impacts the tax system as its needed when designing tax systems, tax rule changes are not made according to the past events or activities already experimented or the complexity to undo what has been done.

Convenience; outlines a taxpayer should be able to easily pay tax (in terms of means and timing of payment). For example PAYE is a very convenient method of collecting tax. It is convenient for people to pay for their taxes during a transaction than to pay in chunks periodically. Other than the administration costs of operating the tax system, there are costs associated due to complexity with the tax rules. Compliance costs are the name given to the complexities in numeric value. Compliance costs include costs associated with keeping records for tax purposes, costs of employing tax related staff, costs linked to collecting data in order to complete the tax returns etc, are imposed on taxpayer when obeying the given tax due.

Efficiency; verifies the cost of collection of tax should be cheap to administer for the government. There should not be impact on the allocation of resources and administration costs to government ought to be avoided. There are two sections to efficiency according to Smith A. (1776). Economic efficiency considers that a tax system is efficient if it does not distort the economic decisions made by individuals. Sometimes this is also referred as neutrality. Tax can influence individuals’ behaviour in numerous ways. Administrative efficiency is when administration costs are kept as low as possible. Increase in administrative costs leads to decrease in revenue left for the government expenditure. Administration costs may include creating return, checking returns, chasing non payment etc. To make sure that the tax system meets the important characteristic equity, it is impossible to have 100% efficient collection system, non-compliance costs are likely to occur. However, to achieve desirable economic efficiency administrative costs should be low as possible.

Other writers have added further characteristics to Smith’s list including simplicity, flexibility and neutral. Flexibility is about responding to economic circumstances over time without having to make substantial changes. Neutral looks at fiscal neutrality, meaning that tax system should not influence behaviour.

For example;

Higher taxes on cigarettes to get people quit smoking. Let’s consider the example of a past, where a late twentieth century tax failed because it was unfair, to understand why equity is important element of tax system. Cowen and Glazer (2005, pp. 214) describes the Community charge, also known as Poll tax, introduced by Margaret Thatcher, was removed due to the opposition by the public against it. With horizontal equity there is the problem of identifying taxpayers with equal taxable capacity. How do you compare taxable capacity of an individual who has substantial wealth, not working and earns income with another? Also another problem is that the tax system in operation at the moment in UK is progressive, which means that tax liability is on incomes from year to year but to have a full horizontal equity it would need to be based on the lifetime income of the taxpayer. This approach would be next to impossible to incorporate in practice. However, if it was to be arranged there would be unforeseen difficulties. Consider this example, how would you tax individual with different life spans? Since Women generally have longer life expectancy than men, should they pay less tax than men if income was to be spread over lifetime, on their taxable capacity, as they will be required to support themselves for more years?

Ability to pay, economic well-being or benefits received are difficult to measure practically. Assume that two individuals doing the same job, individual one does overtime whilst the second one relaxes at home, if tax is measured on income then individual one would have to pay more tax. Is it fair that individual one pays more due to the extra income earned through overtime, whilst the second one relaxed at home? However, if tax was based on ability to earn on income then both the individuals would pay the same amount of tax. With ability to earn a decision should be made whether to use actual income or potential income. Currently actual income is being taxed due to the difficulty in measuring reliable potential income. However, problems exist with actual income if vertical equity is to be achieved. For example two individuals with same income, one decides to save money for retirement and is taxed on the returns earned on the savings. Whilst the other one spends money as it comes and will be given more benefits from the state if extra help is accessible in their old age. In total the individual with saving pays more tax. This is not equitable.

Nightingale K. (2002, pp. 13) states “low paid workers can find themselves in a situation where they earn above the threshold for income tax and National Insurance contributions purposes, but are entitled to state benefit.” The benefit principle is an alternative approach to the use of ‘ability to pay’, which implies that those who benefits most from the services supplied by a government should pay more taxes in order to achieve equity. However, this is difficult to achieve. For example, if individuals do not require some benefits, the government still has to provide many services like defence or law and order as they are public goods which are impossible for citizen to choose whether to consumer or not. Other problems include in achieving equity through benefit principle are how to value benefits received, the time factor in terms of what time scale do you measure the benefit and how this affects the redistribution objectives of a tax system set by the Government.

Part (B)

Income tax was introduced in 1799 to raise revenue for general government expenditure. The present structure of the income tax system came into being in 1973; taxpayers have a tax – free personal allowance and income above this level is taxed and progressively higher rates. In contrast, national insurance started life in 1948 as a social insurance scheme based on the “contributory principle’ – that benefits received should reflect contributions paid. Workers and their employers paid contributions at a flat rate, independent of earnings, in return for entitlement to various flat rate benefits.

Progressive, regressive and proportional taxes are important to understand in order to assess whether the tax is fair or unfair. Progressive tax is when as income raises the tax as a percentage of one’s income increases, which shows tax percentage to be charged for different income bands. Roberts (1994, pp.168) explains “With progressive tax scheme, not only do taxes increase as income increases, but tax increase at a faster pace than income.” Currently UK uses Income tax, which is a best example of a progressive tax. Without paying any income tax. Dilnot et al (1984 pp.151) states “the general indication given is that the British tax system is now more progressive than it have ever been.”Taxing on income is not fully equitable as earnings go unrecorded since there are people on the margins of employment getting paid by cash. Roberts (1994, pp.169) points out that “A person may feel that the fairest tax rate scheme is the one that most benefits (or penalizes least) him or her relatives to other taxpayers (Gerbing 1988).”

The Government firmly believes it is unfair to allow a minority of individuals to benefit financially from shifting part of their income to someone else who is subject to a lower rate of tax – known as income shifting. The Government will instead keep this issue under review (HM Treasury, 2008). This confirms that the UK Government is taking action to meet the characteristics of a good tax system. HM Treasury (2008) states that families on lower incomes are not benefitting from the fairer tax system the Government is working towards and is therefore, going to introduce 10p starting rate of tax as soon as possible. Also key point to consider is that the number of all taxpayers has gone down for the year 2009-10 compared to the previous year, this may be due to recession the country is during this period.

Regressive tax is when as income rises, the tax paid as a percentage of one’s income falls. So a higher earner is paying less tax as a percentage of their income even though they may be paying more tax in absolute terms because the amount paid as tax in falling as income increases. Community charge is an example of regressive tax. Regressive tax system does not meet the characteristic equity and hence why UK does not incorporate it. Proportional tax is however incorporated into the UK tax system. Proportional tax determines that as income increases, more tax is paid but the tax paid as a percentage of one’s income remains unchanged. Some economists consider VAT as proportional tax. It can be argued that as one’s income increases, one’s marginal propensity to consume falls. The increase of electronic commerce and the growth of the intangible economy mean that people are able to avoid the indirect tax VAT since it does not have to be paid over the internet.

“The modern UK income and corporation tax systems represent relatively flexible tax system” Lymer and Oats (2009 pp. 56). As income and business profits increases, the tax raised increases without any direct action from the Government, vice versa equally. This is affected by marginal rates of tax, which in definition means the amount of tax to be paid for extra pound of income earned, is greater than the average rates of tax for most income taxpayers in the UK (an example of a progressive tax system).

Tax avoidance used to be the preserve of the rich. In the next century it will become a national pastime our tax system, designed for an industrial world, will be outmode. The Inland Revenue, a large, bureaucratic organisation, was at its most effective when it was collecting taxes from other large, bureaucratic organisations. It will find life much harder in future (Leadbeater. Leadbeater indicates that the income tax and other taxes will not be meeting the characteristics certainty and equity in the future. For example, many businesses are now set up abroad to avoid corporation taxes in the UK. Leadbeater goes on to say in the future “….perhaps 70 per cent of the UK economy will be made up of services”. As a result, most output will be immaterial, difficult to measure or touch. Businesses over the internet are increasing faster than ever, leaving no physical trail of the transaction carried out. This will allow production to be ever more international. MacGuineas (2004, pp.151) states “The U.S tax system is far less fair than it was a generation ago.” The US is also hit by the rapid changes in economy.

In UK to achieve administrative efficiency, there is the move to self-assessment system of organising income and corporation taxes. However, there is the difficulty of measuring the direct government costs savings and the burden of extra costs to taxpayers. Highfield (2007, pp.6) states “the PAYE arrangements are becoming increasingly more difficult to properly administer for both employers and HMRC and lack the flexibility needed to effectively accommodate some Government policy demands”. There are inaccuracy issues reports from the National Audit Office (NAO) note that end-of-year adjustments needed on about 30% of cases. HMRC reported in 2005 some 3.8 million taxpayer’s paid too much or too little tax, including underpayments of ₤575 million and overpayments of ₤295 million. UK tax system shows lack of flexibility in terms of its incapability to easily hold new entitlements for taxpayers or new Government policy measures.

Before a conclusion can be drawn let us consider couple more analysis from other economists. Myddelton (2003, pp.1) evaluates the extent of merging income taxes, social security taxes and corporation tax into only a single flat-rate of tax on all incomes. “Hence an important part of ‘improving the tax system is to lower its burden: reducing either the average proportion of total tax revenues to national income, or the various indirect compliance costs.” Myddelton goes on to say that to avoid complex and burdensome tax system is to reduce tax taken on proportion of national income and in order to achieve that “in the medium term, is to reduce government spending-either on the provisions of public goods and services, or on transfer payment.” One would agree with Myddelton that the best way of achieving low compliance costs is to avoid tinkering with tax rules and rates, demonstrating that if tax was imposed on a flat tax rate, more people will be motivated to work and invest which in return benefit the whole economy.

The automated recording of all APT tax payments by firms and individuals eliminates the need to file tax and information returns and creates a degree of transparency and perceived fairness that indices greater tax compliance. Also, the tax has lower administrative and compliance cost (Feige 2000, pp. 474). This is another approach that could be taken to improve the UK tax system.

My conclusion is, currently there is no tax system that fulfils all the desirable characteristics outlined by Adam Smith entirely. However, there are some that could be considered. Consider using pre-filled tax returns, (currently developed in number of countries) which is a highly effective method in order to reduce compliance costs related to preparing end-year tax returns. To meet the characteristic efficiency the question needs to be asked here is does UK need two personal income taxes? There are numerous differences between PAYE and NICs that unnecessarily complicates compliance costs for employers collecting vast majority of NICs. For example PAYE operates on a cumulative basis, whilst different approach is applied to NICs. Businesses are regularly calling for reform on high priority due to these complications created through the differences.