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Principles behind the tax system.

It is usually asserted, following Adam Smith, that an individual tax should be certain, that is the payer should be clear as to what is liable to be taxed, how much the tax bill is and when and how to pay it. Another principle is that the cost of collecting a tax should be minimal. Modern taxes are usually very productive in the sense that their collection cost is only a very small percentage of the total raised. There are some exceptions to this and some taxes such as capital gains tax are maintained nowadays as a gesture to the old concept of equality of tax burdens, that is the idea that the rich should bear the greater share of tax.

The principles mentioned above are important but a much more fundamental, and controversial, one is that of equity. It is controversial because it is interpreted in different ways. The consensus used to be that an individual tax or the whole system was equitable if it contained a strong element of progression, that is the higher income groups paid a larger percentage of their income in tax than the lower income groups.

Technically, a tax is progressive if the proportion of income in tax rises with income. A tax is regressive if the proportion of income taken in tax falls as income rises and this includes most indirect taxes on expenditures. It is possible for a tax to be proportionate if the percentage of income taken in tax remains the same as income rises, for example a flat rate 10 % income tax without any allowances.

Another principle that is important is that taxes should not distort the economyto any serious extent unless that is the deliberate intention as demerit goods are taxed. Taxes also affect pricing policies, especially in alcohol, tobacco and petrol markets or in foreign trade if tariffs are levied. A badly designed tax system can seriously affect the allocation of resources within a country and one nation’s tax regime can have an adverse impact on the world economy. An example of the latter effect is the USA whose low tax policy for fuel oil and gasoline leads to the profligate use of scarce world resources.

One important application of the principle of non-distortion is that taxation should not adversely affect the willingness of people to work, to save or to take risks in their enterprise. It is generally “acknowledged that the individual will often have a backward bending” supply curve for their labour because they come to a point where they value extra leisure above the additional income from working longer hours. The level at which they reach this point will be affected by their marginal rate of tax.

Other considerations which can be elevated to the status of principles are:

- minimum impact on the rate inflation. Alteration in most taxes on expenditure affect the RPI (Retail Prices Index) and the rate of inflation. Fuel tax increases are particularly inflationary;

- ease of alteration. The tax mechanism must lend itself to easy and administratively cheap change;

- contribution to economic stabilization. Some taxes aggravate a recession while others fail to help restrain a boom. Indexation of some taxes helps to prevent this tendency but not all taxes can be indexed;

- encouragement to saving. This may be achieved by the differential taxation of savings and expenditure or, in the company sector, by taxing distributed profits more highly than retained profits.