Taxation is the collection of revenues by the state, on a basis not directly linked to the provision of goods and services in return. The term taxation is not usually applied to the sale of goods and services by the state or state enterprises, from which revenues may be earned through prices, fees, or charges. There is an imprecise boundary between taxation and the so-called individual contributions paid in many systems of social insurance; whether such contributions count as taxation depends on how closely individual future entitlements to benefits relate to individual contribution payments.
In most countries, taxation has increased substantially over the past century, and the level of taxation varies considerably between countries. Among the Organization for Economic Cooperation and Development (OECD) countries, revenues from taxation were 28 percent of gross domestic product (GDP) in the United States in 2005, and an average of 40 percent of GDP in the European Union.
Taxes are levied by applying a tax rate, generally specified in percentage terms, to a tax base, the measure of value or quantity subject to taxation. Tax bases employed in most countries include individual income; aggregate business payments of wages and salaries, known as payroll taxes; corporate net income, known as corporate income or profits taxes; and sales by business enterprises, including sales, turnover, and value-added taxes. Many countries also levy taxes on wealth; inheritance; the value of certain classes of assets; or changes in asset values, known as capital gains taxes. Much of tax legislation’s complexity arises in achieving a clear and legally enforceable definition of the tax base; the definition of taxable income is, in particular, complicated by the need to prevent straightforward opportunities for tax avoidance—the artificial restructuring of activity so as to reduce tax liability—such as paying income in kind or converting incomes into capital gains. With these complications in mind, taxation can be analyzed from both a positive and a normative perspective.
The Effects Of Taxation
From the positive perspective, tax incidence concerns where the burden of taxation lies. Formal incidence lies with whoever is liable, according to the legislation, to pay the tax. Thus, for example, a shopkeeper may be liable to pay sales tax on the value of goods sold. Effective or final incidence concerns where the burden of taxation is ultimately borne; it may differ from formal incidence if taxes shift through changes in wages, pr ices, or other economic adjustments. Thus the customer may bear the effective incidence of the sales tax levied on goods sold if the shopkeeper raises prices to reflect the tax. The scope for tax shifting depends on the characteristics of the market. In a competitive market, formal incidence is irrelevant to the determination of effective incidence; altering the legal liability to pay a tax levied on a particular base does not alter where the burden is ultimately felt.
Most countries levy taxes on both individuals and companies. From the perspective of final incidence, all taxes levied on companies are ultimately incident on individuals—as customers, employees, or owners of the taxed companies.
The impact of taxation on behavior affects the incidence of taxes (i.e., large behavioral adjustments tend to be associated with tax shifting) and also affects the economic costs of taxation, in the form of the distortionary impact on the labor supply or savings behavior of individuals and on the production and investment decisions of companies. When taxes lead individuals and firms to make production and consumption decisions that would not be chosen in taxation absence, the economic cost of taxation exceeds the revenue raised. The excess burden of taxation is the net loss in economic welfare occurring when revenues increase through taxes that affect behavior rather than through a tax that has no distortionary impact on behavior (i.e., a lump-sum “poll tax”). Estimates of excess burden vary widely, but as a rough rule of thumb, taxes in most industrialized countries might have an excess burden of at least thirty cents for each dollar raised, and poorly designed taxes have considerably more than this.
Tax Policy Issues
Normative questions concerning taxation include whether the burden of taxation should be distributed across taxpayers according to ability to pay or according to the benefit principle. Taxpayer ability to pay might be defined in terms of individual income or individual consumption (as advocated by Thomas Hobbes in Leviathan). The benefits taxpayers derive from public services are difficult to measure and probably vary widely. Benefit taxation may be most useful as a guide to tax policy for decentralized jurisdictions, since large departures from the benefit principle could induce substantial taxpayer migration to jurisdictions with a more favorable balance between individual tax payments and spending benefits.
The distributional incidence of taxation (i.e., how taxes relate to household ability to pay) may be assessed on a current annual basis or a lifetime basis. Taxes with a percentage of income taken in tax increases at higher levels of income are said to have a progressive distributional incidence, and taxes with a percentage inversely related to ability to pay are called regressive. Income taxes have a greater potential for progressivity than taxes on sales.
Tax policy typically involves a trade-off between equity and efficiency; a higher marginal rate of tax on income (i.e., the additional tax paid when income increases) increases the distributional progressivity of the tax system, but also increases labor market distortions. The economics literature on optimal taxation, beginning with the work of James Mirrlees, considers the structure of taxes that will maximize a social welfare function, giving weight to both efficiency and equity goals. One insight from this literature is the fragility of the case for taxes on the sale of goods and services; if the government is able to levy sophisticated income taxes, taxes on sales make no useful contribution to achieving equity objectives and, in some circumstances, may have higher efficiency costs than equivalent income taxes.
Although tax policy frequently tries to avoid excessive distortionary impacts of taxes on individual and corporate behavior, there has been recent interest in the potential for using taxation to encourage certain types of behavioral change, in particular to encourage individual retirement provision and to discourage environmentally damaging production and consumption activities.
Taxes may be levied at various levels of government. Municipalities and other lower-tier government units frequently employ taxes on real estate, both because the tax base can be unambiguously assigned to an individual jurisdiction and because the tax base is largely immobile. Some other taxes are more complex to operate at a local level, because the tax base cannot easily be assigned to local jurisdictions (e.g., corporate profits may be earned through business activity in many localities). Also, behavioral responses to tax differences across jurisdictions may be more severe, so that jurisdictions are constrained by the tax rates set by their neighbors, and tax policies may compete to attract mobile tax bases. There are differing views whether such tax competition is desirable. Some see tax competition as a desirable constraint on excessive government; others emphasize the potential inefficiency of tax competition through “base stealing.” With increasing globalization, issues of tax competition arise between countries as well as between subcentral jurisdictions within a country. Major issues include the tax treatment of the foreign earnings of multinational companies and the use of transfer pricing to shift a multinational’s profits to low-tax countries.
A relatively underexplored area is the determination of the tax structure—why some countries rely more on certain taxes than on others. Some aspects of tax structure are very durable over time—and tax privileges for certain activities appear much easier to legislate than repeal. In addition, tax policy making in many countries is a highly politicized process, exposed to substantial lobbying and public debate, and differences in the political process may account for some of the differences in tax systems across countries.
- Heady, Christopher. “Optimal Taxation as a Guide to Tax Policy.” Fiscal Studies 14, no. 1 (1993): 15–41.
- Institute for Fiscal Studies, ed. Dimensions of Tax Design: The Mirrlees Review. Oxford: Oxford University Press, 2009.
- Slemrod, J., ed. Tax Policy in the Real World. Cambridge: Cambridge University Press, 1999.
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