Tax

A tax is an involuntary fee or, more precisely, "unrequited payment", paid by individuals or businesses to a government (central or local). Taxes may be paid in cash or kind (although payments in kind may not always be allowed or classified as taxes in all systems). The means of taxation, and the uses to which the funds raised through taxation should be put, are a matter of hot dispute in politics and economics, so discussions of taxation are frequently tendentious.

The field of economics that deals with taxation is public finance.

Purposes and effects of taxation

Governments collect taxes:

to support the operation of that government itself;
to influence the macroeconomic performance of the economy (the government's strategy for doing this is called its fiscal policy);
to carry out the functions of the government, such as national defence, and providing government services
to redistribute resources between individuals or classes in the population. Historically, the nobility were supported by taxes on the poor; modern social security systems are intended to support the poor by taxes on the rich.
to modify patterns of consumption or employment within an economy, by making some classes of transaction more or less attractive.

The resource taken from the public through taxation is always somewhat greater than the amount which can be used by the government. The difference is called compliance cost, and includes for example the labour cost and other expenses incurrend in complying with tax laws and rules.

The collection of a tax in order to spend it on a specified purpose, for example collecting a tax on alcohol to pay directly for alcoholism rehabilitation centres, is called hypothecation. The practice is often disliked by finance ministers, since it reduces their freedom of action. Some economic theorists consider the concept to be intellectually dishonest since in reality money is fungible. Furthermore, it often happens that taxes or excises initially levied to fund some specific government programs are then later diverted to the government general fund.

Some economists, especially neo-classical economists argue that all taxation distorts the market and results in economic inefficiency. They have therefore sought to identify the kind of tax system that would minimise this distortion. A theory is that the most economically neutral tax is a tax on land. A government's primary duty is to maintain and defend title to land, and therefore (so the theory goes) it should collect most of its revenues for this unique service. Since governments also resolve commercial disputes, especially in countries with common law, this doctrine is often used to justify a sales tax or VAT (value-added tax). Others (e.g. libertarians) argue that most or all forms of taxes are immoral due to their involuntary (and therefore eventually coercive/violent) nature.

Tax rates

Taxes are most often levied as a percentage, called the tax rate, of a certain value, the tax base (how much income and assets one has, earns, spends, inherits, etcetera). An "Ad Valorem" tax is one where the tax base is the value of a good, service, or property. Sales taxes, tariffs, property taxes, inheritance taxes, and value added taxes are different types of ad valorem tax. An ad valorem tax is typically imposed at the time of a transaction (sales tax or value added tax (VAT)) but it may be imposed on an annual basis (property tax) or in connection with another significant event (inheritance tax or tariffs). The alternative to ad valorem taxation is a fixed rate tax, where the tax base is the quantity of something, regardless of its price: for example, in the United Kingdom a tax is collected on the sale of alcoholic drinks that is calculated on the quantity of alcohol contained rather than the price of the drink.

Progressive and regressive taxation

An important feature of tax systems is whether they are flat (the percentage does not depend on the base, hence the tax is proportional to how much you earn, have, or spend), regressive (the more you have the lower the tax rate), or progressive (the more you have the higher the tax rate). Progressive taxes reduce the tax burden of people with smaller incomes, since they take a smaller percentage of their income. This may be viewed as a good thing in itself, or it may be done for pragmatic reasons, since it requires less record-keeping and complexity by people with simpler affairs.

Direct and indirect taxation

Taxes are sometimes referred to as direct or indirect. The meaning of these terms can vary in different contexts, which can sometimes lead to confusion. In economics, direct taxes refer to those taxes that are paid by the people or organizations on whom they are imposed. For example, income taxes are paid by the person who earns the income. By contrast, the cost of indirect taxes is borne by someone other than the person responsible for paying them. For example, taxes on liquor or gasoline are often included in the price of the items, so even though the seller sends the payments to the government, the buyer is the real payer. Indirect taxes are sometimes described as hidden taxes because the purchaser of goods or services may not be aware that a proportion of the price is going to the government.

In law, the terms may have different meanings. In US constitutional law, for instance, direct taxes refer to poll taxes and property taxes, which are based on simple existence or ownership. Indirect taxes are imposed on rights, privileges, and activities. Thus, a tax on the sale of property would be considered an indirect tax, whereas the tax on simply owning the property itself would be a direct tax.

The distinction can be subtle, but it is important under US law, since the United States Constitution formerly required that direct taxes be apportioned according to population. That is, if one state had twice the population of another state, then the direct tax revenue from that state must be exactly twice that from the other state. In 1895, the US Supreme Court interpreted the income tax as a direct tax when applied to income from property, and struck down the tax as a result. The federal government then had no income tax until the Sixteenth Amendment was ratified, which removed the apportionment requirement for income taxes.

Economics of Taxation

Some economists view taxes as creating inefficiencies in the economy.

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Figure 1: Equilibirum

Figure 1 indicates a good without any government interference. This good could represent anything from televisions to labour. At this equilibrium quantity Q1 of the good are sold at price P1. The consumer and producer surplus are both high.

Figure 2: With a tax

Figure 2 shows the introduction of a very simple tax. The tax charges a flat fee whenever a consumer wishes to purchase the good. The price thus rises to P2, and since fewer consumers wish to purchase the good at the higher price, the quantity produced falls to Q2. The government receives the amount of the tax for each unit sold, and this amounts to the region shown in grey. This is the amount of revenue the government receives for this tax.

Note that in this situation the price of the good to consumers only increases by half the amount of the tax, the other half of the tax is borne by the producer. Thus both consumer and producer surpluses shrink by equal amounts. For many goods this is not the case. Who bears the cost of the tax is determined by the elasticity of the good. For inelastic goods like cigarettes, and gasoline almost all of the tax is paid by the consumer.

Also note that this flat tax is extremely simplistic. Almost all taxes are a percentage of the cost of the good, many are also progressive. This is especially true with income taxes.

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Figure 3: Net Societal Loss

The tax is not a simple transfer of wealth from producers and consumers to government. A perminant loss of surplus available to society occurs, shown in orange. This inefficiency loss is often called dead weight loss or the excess burden of taxation. This shrinkage of the surplus available to society is a reason why many economists dislike taxes.

This model does not take into account what the government uses the tax money for, however, and a tax could be justified if it removes other greater inefficiencies in the economy, such as negative externalities or monopolies. In these cases a tax can be used as a tool, known as a pigouvian tax, to reduce the inefficiency in the market.

Types of Taxes

Income tax

Income tax is commonly a progressive tax because the tax rate increases with increasing income. For this reason, it is generally advocated by those who think that taxation should be borne more by the rich than by the poor, even to the point of serving as a form of social redistribution. Some critics characterize this tax as a form of punishment for economic productivity. Other critics charge that income taxation is inherently socially intrusive because enforcement requires the government to collect large amounts of information about business and personal affairs, much of which could be considered proprietary.

The crucial invention permitting the reliable collection of high income taxes was direct withholding of taxes from payrolls by employers; this works because most people in modern societies are salaried workers. This reduces the perceived burden of the tax, because employees never handle the money. Direct withholding also discourages cheating, because it requires the collaboration of employers, and as there are fewer employers than employees, the government's enforcement efforts can be deployed more effectively. However, direct withdrawal also has some drawbacks: it puts part of the burden of processing taxes on the employer, and it also complicates matters when the employee is in a situation where he or she should pay significantly less or more than what is expected from its salary (because of tax-deductible expenses, or side revenues). Direct withholding is the method of collection of choice in most countries implementing income taxes, with the exception of France, where direct withholding is periodically discussed, but has so far not been implemented.

Where income tax is not collected at source, it may become easier to cheat by lying about one's affairs. The government may then require that employers report the amounts they pay to employees.

Income tax, in addition to income, generally takes into account a variety of factors. Certain expenses, such as work-related expenses, donations to charities etc..., may be tax-deductible: that is, they are subtracted from the taxable revenue. Investments in some impoverished areas or industrial sectors may be encouraged through tax breaks (reduced rates). Donations to charities may be partly subtracted from the tax, in an original form of subsidy. Because of various exemptions, rebates etc..., income tax codes tend to be complicated. In some countries such as the United States, individuals often hire the service of a tax accountant so as to find the best way to reduce their tax.

Income tax fraud is a problem in most, if not all, countries implementing an income tax. Either one fails to declare income, or declares nonexistent expenses. Failure to declare income is especially easy for non-salaried work, especially if paid in cash. Tax enforcement authorities fight tax fraud using various methods, nowadays with the help of computer databases. They may, for instance, look for discrepancies between declared revenue and expenses along time. Tax enforcement authorities then target individuals for a tax audit – a more or less detailed review of the income and tax-deductible expenses of the individual.

Poll tax

A poll tax, or capitation tax, is a tax that levies a set amount per individual. The earliest tax mentioned in the Bible of a half-shekel per annum from each adult Jew (Ex. 30:11-16) was a form of poll tax. Poll taxes are regressive, since they take the same amount of money (and hence, a higher proportion of income) for poorer individuals as for richer individuals. Poll taxes are difficult to cheat. A poll tax may also be called a per capita tax or a capitation or payroll tax.

Excises

Definition

An excise is a type of ad valorem tax that is imposed at the time of a purchase or sale transaction (sales tax or value-added tax (VAT)) or in connection with importation across a political border (tariffs). The tax base may be the purchase price or the declared value, or some standard estimate of a fair price: for example, the sales tax on used automobile purchases in the United States is determined with reference to a published list of prices. The purchase price may be disregarded.

Purposes and effects of excises

Excises on particular commodities are frequently hypothecated. For example, a fuel excise is often used to pay for public transportation, especially roads and bridges and for the protection of the environment. A special form of hypothecation arises where an excise is used to compensate a party to a transaction for alleged uncontrollable abuse: for example, a blank media tax is a tax on recordable media such as CD-Rs, whose proceeds are typically allocated to copyright holders. Critics charge that such taxes tax blindly those who make legitimate and illegitimate usages of the products; for instance, a person or corporation using CD-R's for data archival should not have to subsidize the producers of popular music.

Excises (or exemptions from them) are also used to modify consumption patterns. For example, a high alcohol excise is used to discourage alcohol consumption, relative to other goods. This may be combined with hypothecation if the proceeds are then used to pay for the costs of treating illness caused by alcohol abuse. Similar taxes may exist on tobacco, pornography etc..., and they may be collectively referred to as sin taxes. A carbon tax is a tax on the consumption of carbon-based non-renewable fuels, such as petrol, diesel-fuel, jet fuels and natural gas. The object is to reduce the release of carbon into the atmosphere. In the UK Vehicle Excise Duty is an annual tax on vehicle ownership.

Sales tax

Sales taxes are a form of excise levied when a commodity is sold to its final consumer. They are generally held to discourage retail sales. The question of whether they are generally progressive or regressive is a subject of much current debate. People with higher incomes spend a lower proportion of them, so a flat-rate sales tax will tend to be regressive. It is therefore common to exempt food, utilities and other necessities from sales taxes, since poor people spend a higher proportion of their incomes on these commodities, so such exemptions would make the tax more progressive. The classic way of cheating on sales tax is to ask a merchant or service provider for a cash discount. The merchant pockets the cash and writes off the merchandise to shrinkage and the state fails to get the tax.

Tariffs

An import or export tariff is a charge for the movement of goods through a political border. Tariffs discourage trade, and they may be used by governments to protect domestic industries. A proportion of tariff revenues is often hypothecated to pay government to maintain a navy or border police. The classic way of cheating a tariff is smuggling.

Value-added tax

A value-added tax (also called a goods and services tax) applies the equivalent of a sales tax to every operation that creates value. Economic theorists have argued that this minimises the market distortion resulting from the tax. A VAT was historically used when a sales tax or excise tax was uncollectable. For example, a 30% sales tax is so often cheated that most of the retail economy will go off the books. VAT distributes such a tax in small enough increments that it becomes more trouble to cheat than to pay the tax. However, a VAT punishes production, which is considered a bad effect.

Stamp duty

Historically, in many countries, a contract needed to have a stamp afixed to make it valid. The charge for the stamp was either a fixed amount or a percentage of the value of the transaction. In most countries the stamp has been abolished but stamp duty remains. Stamp duty is levied in the UK on the purchase of shares and securities, the issue of bearer instruments, and certain partnership transactions. Its modern derivatives, stamp duty reserve tax and stamp duty land tax, are respectively charged on transactions involving securities and land. Stamp duty has the effect of discouraging speculative purchases of assets by decreasing liquidity. Taxes on currency transactions are known as Tobin taxes.

Property taxes

A property tax is usually levied on the value of property owned, usually real estate. Property taxes may be charged on a recurrent basis, or on upon a certain event. The two most most common type of event driven property taxes are stamp duty, charged upon change of ownership, and inheritance tax, which is imposed in many countries on the estates of the deceased. Some believe that inheritance taxes do not have any harmful effect on the economy and may even be beneficial as they encourage consumer spending by the elderly. However, they are also believed to discourage productivity and to disrupt the continuity of family-owned businesses. Another common type of property tax is an annual charge on the ownership of real estate, where the tax base is the supposed value of the property. For a period of over 150 years from 1695 a window tax was levied in England, with the result that you can still see listed buildings with windows bricked up [1] in order to save their owner's money. A similar tax existed in France, with similar results.

Capital gains tax

A capital gain tax is the tax levied of the profit realised upon the sale of an asset.

Corporation tax

Corporation tax is a tax on the profits of a company. In most countries the taxable profit is the difference in the value of the company from the last time corporation tax was levied.

A History of Taxation

Political authority has been used to raise capital throughout history. In many pre-monetary societies, such as the Incan empire, taxes were owed in labor. Taxation in labour was the basis of the Feudal system in medieval Europe. King Solomon of the Old Testament pointed to the need for taxes to be applied for civil purposes (1 Kings 4:7; 9:15; 12:4), and these amounts were increased during times of foreign occupation.

In more sophisticated economies such as the Roman Empire, tax farming developed, as the central powers could not practically enforce their tax policy across a wide realm. The tax farmers were obligated to raise large sums for the government, but were allowed to keep whatever else they raised. The early Christians of the New Testament including Jesus supported the payment of taxes. "Render unto Caesar the things that are Caesar's". It is even recognized as a duty whether as a "telos" on merchandise or travellers (Matt. 17:25), an annual "phoros" on property tax (Luke 20:22;23:2), a "kensos" or poll tax (Matt. 22:17; Mark 12:14, or the tribute money of a temple-tax (Matt. 17:24-27).

There were certain times in the middle ages where the governments did not explicitly tax, since they were self supporting, owning their own land and creating their own products. The appearance of doing without taxes was however illusory, since the government's (usually the Crown's) independent income sources depended on labour enforced under the feudal system, which is a tax exacted in kind.

Historical forms of taxation

In monetary economies prior to fiat banking, a critical form of taxation was seigniorage, the tax on the creation of money. Seigniorage has been replaced by central banking.

Other obsolete forms of taxation include:

scutage - paid in lieu of military service; strictly speaking a commutation of a non-tax obligation rather than a tax as such, but functioning as a tax in practice
tallage - a tax on feudal dependants
a tithe - a tax, or more precisely a tax-like payment, (one tenth of one's earnings or agricultural produce), paid to the Church (and thus too specific to be a tax in strict technical terms even though appearing as one to the payer)

Some principalities taxed windows, doors or cabinets to reduce consumption of imported glass and hardware. Armoires, hutches and wardrobes were invented to evade taxes on doors and cabinets.

External links

About Taxes
International Tax News - Daily updated taxation news courtesy of Ocra Worldwide.