Taxation – Classification, Types and Principles
Table of Contents
Taxation – Classification, Types and Principles of Taxation
TAXES:
Introduction to Tax:
- [13th century. Via French < Latin taxare “censure, assess” < tangere “to touch”]
- An amount of money levied by a government on its citizens and used to run the government, the country, a state, a county, or a municipality is called Tax. _ LoF
- Taxation, a system of raising money to finance the government.
- All governments require payments of money—taxes—from people.
- Governments use tax revenues to pay soldiers and police, to build dams and roads, to operate schools and hospitals, to provide food to the poor and medical care to the elderly, and for hundreds of other purposes. Without taxes to fund its activities, the government could not exist.
- Taxation is the most important source of revenues for modern governments, typically accounting for 90 percent or more of their income. The remainder of government revenue comes from borrowing and from charging fees for services.
CLASSIFICATION OF TAXES:
- Taxes may be Proportional, Progressive, Regressive, and Degressive.
Proportional Tax:
- A proportional tax takes the same percentage of income from all people.
- A proportional tax is one in which whatever the size of income, same rate or same proportional % is charged.
- If all taxpayers have to pay to say 1% of their income as the tax is known as the Proportional tax.
Progressive Tax:
- 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.
- The principle is ‘higher the income; higher the rate’.
- Eg a person earning 5000/- pay 1 % while another person earning 10,000 may have to pay 2 %.
Regressive Tax:
- 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.
- It is the opposite of the progressive tax.
- Eg community tax, when govt increases sugar rate from 60 Rs/ kg to 70 Rs/kg, it is for both poor and rich but it is the burden on poor people.
Degressive Tax:
- A tax is called degressive when the higher incomes do not make a due sacrifice, or when the burden imposed on them is relatively less ie the tax may be progressive up to a certain limit beyond which a uniform rate is changed.
- So there will be a lower relative sacrifice on the larger incomes than on the smaller incomes.
TYPES OF TAXES:
- Governments impose many types of taxes. In most developed countries, individuals pay income taxes when they earn money, consumption taxes when they spend it, property taxes when they own a home or land, and in some cases estate taxes when they die.
Individual Income Tax:
- An individual income tax, also called a personal income tax, is a tax on a person’s income. Income includes wages, salaries, and other earnings from one’s occupation; interest earned by savings accounts and certain types of bonds; rents (earnings from rented properties); royalties earned on sales of patented or copyrighted items, such as inventions and books; and dividends from stock.
- Income also includes capital gains, which are profits from the sale of stock, real estate, or other investments whose value has increased over time.
- Each taxpayer must compute his or her tax liability—the amount of money he or she owes the government. (This computation involves four major steps. (1) The taxpayer computes adjusted gross income—one’s income from all taxable sources minus certain expenses incurred in earning that income. (2) The taxpayer converts adjusted gross income to taxable income—the amount of income subject to tax—by subtracting various amounts called exemptions and deductions. Some deductions exist to enhance the fairness of the tax system. For example, the U.S. government permits a deduction for extraordinarily high medical expenses. Other deductions are allowed to encourage certain kinds of behavior. For example, some governments permit deductions of charitable contributions as an incentive for individuals to give money to worthy causes. (3) The taxpayer calculates the amount of tax due by consulting a tax table, which shows the exact amount of tax due for most levels of taxable income. People with very high incomes consult a rate schedule, a list of tax rates for different ranges of taxable income, to compute the amount of tax due. (4) The taxpayer subtracts taxes paid during the year and any allowable tax credits to arrive at final tax liability).
- After computing the amount of tax due, the taxpayer must send this information to the government and enclose the amount due. Eg In 2001 the average taxpayer in the United States paid about 15 percent of his or her income in income taxes.
Corporate Income Tax:
- (In many countries) All corporations must pay tax on their net income (profits) to the federal government.
- Corporate tax rates generally increase with income. For example, in the USA, in 2001 corporations with profits of up to $50,000 paid 15 percent in taxes, whereas corporations with profits greater than about $18.3 million were taxed at a flat rate of 35 percent. In Canada, the basic rate for corporations was 28 percent in 2000.
- The corporate income tax is one of the most controversial types of taxes.
- It leads to double taxation of corporate income. Income is taxed once when it is earned by the corporation, and a second time when it is paid out to shareholders in the form of dividends. Thus, corporate income faces a higher tax burden than income earned by individuals or by other types of businesses.
- Some economists have proposed abolishing the corporate income tax and instead taxing the owners of corporations (shareholders) through the personal income tax.
Payroll Tax:
- Whereas an income tax is levied on all sources of income, a payroll tax applies only to wages and salaries. For most people, payroll taxes are the second-largest tax they must pay each year, after individual income taxes.
- Employers automatically withhold payroll taxes from employees’ wages and forward them to the government.
- Payroll taxes are the main sources of funding for various social insurance programs, such as those that provide benefits to the poor, elderly, unemployed, and disabled.
Consumption Tax:
- A consumption tax is a tax levied on sales of goods or services.
- The most important kinds of consumption taxes are general sales taxes, excise taxes, value–added taxes, and tariffs.
- General sales taxes and excise taxes are the largest sources of revenue for state and local governments for a number of countries.
General Sales Tax:
- A general sales tax imposes the tax on a wide variety of goods and, in some cases, services.
- State sales taxes range from 3 to 7 percent, and local sales taxes range from a fraction of 1 percent to 7 percent.
- Although sellers are legally responsible for paying sales taxes, and sellers collect sales taxes from consumers, the burden of any given sales tax is often divided between sellers and consumers.
Excise Tax:
- Excise taxes are also called selective sales taxes.
- These are sales taxes on specific goods or services.
- Goods subject to excise taxes in the US include tobacco products, alcoholic beverages, gasoline, and some luxury items.
- Excise taxes are applied either on a per unit basis, such as per package of cigarettes or per liter or the gallon of gasoline or as a fixed percentage of the sales price.
Value-added Tax (VAT):
- In this system, the seller pays the government a percentage of the value added to goods or services at each stage of production.
- The value added at each stage of production is the difference between the seller’s costs for materials and the selling price.
- In essence, a VAT is just a general sales tax that is collected at multiple stages.
Tariffs:
- Tariffs, also called duties or customs duties, are taxes levied on imported or exported goods.
- Import duties are considered consumption taxes because they are levied on goods to be consumed. Import duties also protect domestic industries from foreign competition by making imported goods more expensive than their domestic counterparts.
Property Tax:
- In principle, a property tax is a tax on an individual’s wealth—the value of all of the person’s assets, both financial (such as stocks and bonds) and real (such as houses, cars, and artwork).
- In practice, property taxes are usually more limited.
Estate, Inheritance, and Gift Taxes:
- An estate tax is a tax on the deceased person’s estate, which includes everything the person owned at the time of death—money, real estate, stock, bonds, proceeds from insurance policies, and material possessions.
- Most governments levy estate taxes before the deceased person’s property passes to heirs, although many governments do not impose an estate tax on property inherited by a spouse.
- An inheritance tax also taxes the value of the deceased person’s estate, but after the estate passes to heirs. The inheritors pay the tax.
- Estate and inheritance taxes are sometimes collectively called death taxes.
- A gift tax is a tax on the transfer of property between living people.
Other Taxes:
- A poll tax also called a lump-sum tax or head tax, collects the same amount of money from each individual regardless of income or circumstances.
- Poll taxes are not widely used because their burden falls hardest on the poor.
- A pollution tax is a tax levied on a company that produces air, water, or soil pollution over a certain level established by the government.
- The tax provides an incentive for companies to pollute less and thus reduce damage to the environment.
- The United States, France, Germany, and The Netherlands all levy taxes on some types of pollution. However, these taxes account for just a tiny amount of total tax revenue. In Canada, some provincial governments levy pollution taxes.
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).
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.
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Ability-to-pay principle:
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- 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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The benefits principle:
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- 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.
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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Administration Costs:
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- Running a tax collection authority costs money. The government must hire tax collectors to gather revenue, data entry clerks to process tax returns, auditors to inspect questionable returns, lawyers to handle disputes, and accountants to track the flow of money.
- No tax system is perfectly efficient, but the government should strive to minimize the costs of administration.
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Compliance costs:
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- Complying with the system—paying taxes—costs taxpayers money above and beyond the actual tax bill. These costs include the money that people spend on accountants, tax lawyers, and tax preparers, as well as the value of taxpayers’ time spent filling out tax returns and keeping records.
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Excess burden:
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- The third measure of a tax system’s efficiency takes into account the fact that when the government levies a tax on a good, it distorts consumer behavior—people buy less of the taxed good and more of other goods.
- Instead of choosing what goods to buy solely on the basis of their intrinsic merits, consumers are influenced by taxes.
- This tax-induced change in behavior is called an excess burden. The larger the excess burden of a tax, the worse it is for efficiency.
TERMS ASSOCIATED WITH TAXATION:
_ from LoF (Lexicon of Forestry)
Consumption tax: A tax levied on sales of goods or services. Consumption taxes include general sales taxes, excise taxes, value-added taxes, and tariffs.
Corporation income tax: A tax on the profits, or net income (total income minus costs), of corporations.
Direct tax: A tax whose burden falls directly on the person or thing taxed and cannot be shifted to another person or thing. A poll tax is an example of a direct tax.
Estate tax: A tax on the property (including real, personal, and intangible property) left by a person at death.
Excise tax: A selective sales tax, imposed only on the sale of specific goods.
Gift tax: A tax on the value of gifts received by an individual in excess of a certain sum per year and over a certain cumulative amount over a person’s lifetime.
Horizontal equity: The principle that people in equal positions or situations should pay the same amount of tax.
Indirect tax: A tax imposed on one person or thing but whose burden is borne indirectly by another. A sales tax though imposed on and collected from the seller is an indirect tax on the buyer.
Individual income tax: A tax on the income of individuals or families, generally applied to wages, salaries, tips, interest, and dividends. Also called personal income tax.
Inheritance tax: A tax on the income (including property) received by an heir from the estate of a person who has died. Bequests to charitable organizations are not taxed.
Marginal tax rate: The tax rate applied to a particular tax bracket (a designated range of taxable income).
Payroll tax: A tax on wages and salaries (income earned for work), used to finance social insurance programs that provide benefits to the poor, the elderly, the unemployed, and the disabled.
Poll tax: A tax of a specific monetary amount imposed directly on an individual. Also called a lump-sum tax or head tax. In the United States, the term also refers to a tax (now prohibited) imposed on citizens as a requirement for voting.
Pollution tax: A tax levied on a company that produces air, water, or soil pollution over a certain level established by the government.
Progressive tax: Generally, a tax that imposes a heavier burden on those more able to bear the burden than on those less able to bear it. When applied to income, which is the most important tax base in developed countries, a progressive tax is one that takes a greater percentage of income from those with higher incomes than from those with lower incomes.
Property tax: A tax on property, usually meaning only real property, such as land, buildings or houses, and machinery. Personal property, such as furniture, vehicles, or jewelry, is largely excluded, as is intangible property, such as money, stocks, bonds, or bank deposits.
Proportional tax:
A tax that imposes the same burden on people or takes the same percentage of each person’s income.
Regressive tax: A tax that imposes a heavier burden on those less able to bear it. Applied to income, it is a tax that takes a greater percentage of income from people with low incomes than from those with high incomes.
Sales tax, general: A tax imposed on the sale of a wide range of goods and services. Although collected from sellers at the retail level, consumers bear the cost of sales taxes.
Tariff: A tax levied on imported or exported goods. Also called duty or customs duty.
Tax base: The object on which a tax is based or calculated, such as income (the base of the income tax), property (the base of the property tax), or the individual (the base of the poll tax).
Tax incidence: The way a tax affects people. The statutory incidence of a tax refers to who must legally pay the tax. The economic incidence of a tax refers to who bears the actual burden of a tax.
Tax rate: The percentage of the value of the tax base that must be paid in tax or the amount of tax charged in the case of a direct poll tax.
Tax schedule: The set of rates applicable to different amounts of the tax base. Under the income tax, for example, the schedule shows the rates applicable at each level of income.
Value-added tax: A percentage tax on the value added to goods or services at each stage of production and distribution. As with general sales taxes, consumers bear the final burden of value-added taxes.
Vertical equity: The principle that a tax system should distribute burden fairly across people with different abilities to pay.
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