|Supplements to this article include a glossary and tabulations of the composition of taxation and international comparisons of the tax burden, of the tax wedge and of marginal tax rates.|
The essential functions of taxation are to finance public expenditure and to service the national debt. It can also be used to create a more equitable distribution of wealth, but its use for that purpose tends to reduce economic growth. The economics of taxation is about opportunities to reduce its harmful effect on growth without reducing its contribution to equity: or to increase its contribution to equity without increasing its harmful effect upon growth.
This article is about the political, social and microeconomic effects of taxation. The macroeconomic effects of taxation, and the effects of varying combinations of taxation, public expenditure and debt, are dealt with in the article on fiscal policy.
Attitudes to taxation
Substantial international differences are revealed in the comparison presented on the addendum subpage national burden of taxation, due probably to differences in political attitudes. Most people accept the need for taxation - although many people object to the present levels of taxation because they do not believe that what it is spent on is good value. In many countries, however, there are influential minorities who consider all taxation of income to be unfair because it deprives the taxpayer of something that is rightfully his. In the late 19th century, the then popular American economist, Henry George argued that it is "primarily, the right of a man to himself, to the use of his own powers, to the enjoyment of the fruits of his own exertions" (and that) "as a man belongs to himself, so his labor when put in concrete form belongs to him"., and in the 1970s the political philosopher Robert Nozick claimed on similar grounds that "the taxation of earnings from labor is on a moral par with forced labor". The contrary case has been developed by law professors Stephen Holmes and Cass Sunstein who have argued that liberty depends upon taxation because the protection of liberty has costs that have to be paid for, supported by others who have argued that property ownership would have no meaning without taxation since the alternative would be a world without government as described in Thomas Hobbes' Leviathan as a "war of all against all".
Robert Nozick and his fellow libertarians generally accept the need for some form of taxation to pay for public goods such as defence and law and order, but object to its use for the redistribution of wealth. Professors Holmes and Sunstein have argued, however, that redistribution is unavoidable and that it is not always in favour of the needy, but also happens when public resources are used to protect the property of the rich. And the political theorist Stuart White has argued that everyone that shares in the benefits of public expenditure has an obligation to make a proportionate contribution to the community in return.
The components of taxation
Personal income tax
Personal income tax accounts for about 25 per cent of the average tax receipts of the OECD countries. Taxable income is defined in a variety of ways, with many different allowances, exemptions and deductions. Tax rates are generally progressive, usually starting after a tax-free range for the lowest incomes, and followed by a sequence of higher rates as successive "thresholds" are exceeded, to reach maximum (and marginal) rates that are mostly between 40 per cent and 60 per cent . Income from investments and income from employment are sometimes treated differently and there is sometimes special treatment for the elderly. The total tax wedge between employees' take-home pay and total labour costs to employers (including employee and employer social security contributions) ranges for most OECD countries to between 25 and 50 per cent of employers labour costs).
Social security contributions
Social security contributions account for about 24 per cent of the average tax receipts of the OECD countries. They include employees and employers contributions toward: -
- unemployment insurance benefits;
- accident, injury and sickness benefits;
- old-age, disability and survivors’ pensions;
- family allowances: and,
- reimbursements for medical and hospital expenses or provision of hospital or medical services.
The total of employees' and employers social security contributions amounts for most OECD countries to a tax wedge of between 10 and 30 per cent of employers' labour costs.
Corporate income tax
Corporate income tax accounts for about 11 per cent of the average tax receipts of the OECD countries and tax rates are mainly between 15 per cent and 35 percent . As for personal taxation, many different ways of defining taxable income have been adopted, often with allowances for depreciation or research and development and with "tax breaks" for selected commercial activities, and with special treatment of small businesses. In principle there are also the options of "source-based", "residence-based" or "destination-based" systems (ie related to the location of the parent company, residence of the investor or the location of the final sale).
Taxes on consumption
Taxes on consumption (also known as "indirect taxes") have generally been increasing in recent years , and now account for about 25 per cent of the average tax receipts of the OECD countries. They include
- sales taxes (mainly in the US);
- value added tax - that is immediately paid on purchases at all stages of the supply chain, but subsequently deducted at all stages except purchases by the final consumer (in use in all OECD countries except the US);
- excise taxes - that are paid only on purchases of specified categories of product, such as tobacco and alcohol and petrol;
- tariffs - that are paid on imported goods (mainly agricultural products).
It is common practice to exempt commodities on which poor people spend relatively high proportions of their income, such as food and childrens'clothing.
Taxes on wealth and property
The principal categories of redistributive taxes on property and personal wealth are:
- Taxes on fixed property (real estate)
- Taxes on net wealth and capital gains
- Estate duty, inheritance tax, gift tax
- Taxes on financial and capital transactions
Among the taxes that have been adopted in pursuit of environmental objectives are:
- Taxes on energy use. European Union law requires member states to use "financial instruments" to bring about reductions in the use of energy in pursuit of a target reduction of 9 per cent over a period of 9 years . Implementation is being attempted partly by taxation - for example, the UKs Climate Change Levy
- Carbon taxes. Taxes design to reduce the emission of carbon dioxide and other "greenhouse gases" have been introduced in a number of European and Commonwealth countries and in some member states of the United States, but "tradable permit" schemes provide an alternative that is widely favoured,
- Landfill taxes. European law sets limits upon the amount of biodegradable municipal waste that member states may send to landfill sites .
- (A comprehensive classification of taxes is available from the OECD)
The effects of taxation
Every combination of the various forms of taxation has a different effect upon welfare, but they all have certain common features. In the terminology of economic theory, each of them has an income effect, and most of them have substitution effects. The income effect is the reduction in the resources available to taxpayers that is brought about by the transfer of resources to government. It occurs, therefore, without affecting the total of the country's resources. The substitution effect, on the other hand, may result in a reduction in the country's resources by bringing about a move to less productive activity. An increase in income tax may, for example, induce a skilled worker to reduce his working hours and spend more time on untaxed do-it-yourself activities. The resulting reduction in output would have the indirect effect of reducing national welfare. The substitution effect may alternatively have a direct effect of welfare by prompting taxpayers to buy products other than those that they would otherwise prefer. A tax on biscuits, for example, may prompt buyers to switch to an untaxed but less enjoyable product, such as bread. The size of the substitution effect depends upon the extent to which the tax varies with a level of activity (the marginal tax rate) and to the responsiveness of the level of that activity to its price (the elasticity of supply or demand). Taxes that have no effect upon supply or demand, such as a land-value tax or a poll tax, have no substitution effect, and activities whose level is relatively insensitive to price (such as purchases of bread) have relatively small substitution effects. Other things being equal the more numerous the persons or activities on which the tax is leveled (ie the larger the "tax base"), the smaller is likely to be the substitution effect because the lower are the marginal tax rates
A second common feature is the effect of taxation upon the distribution of income and wealth. The term ‘’vertical distribution’’ refers to distribution among people having different levels of income, and the term "progressive tax" denotes a tax which bears progressively more heavily on higher- income taxpayers. However, a tax which is the same whatever the taxpayer’s income, such as a poll tax, is termed "regressive" because it is harder for low-income taxpayers to afford it. The term ‘’horizontal distribution’’ is correspondingly taken to refer to the distribution of taxation among taxpayers who have similar levels of income, but the term is open to a variety of interpretations. The exemption from tax liability for specific classes of potential taxpayer is often referred to as a ‘’tax break’’ and is indistinguishable from subsidies in favour of those classes. Tax breaks for specific activities, such as research and agriculture - or for specific classes of organisation, such as charities and the arts, are intended to encourage those activities or organisations; and tax breaks for specific classes of individual such as the elderly or mothers with small children, are often intended to alter vertical distribution.
The burden of taxation may not fall exclusively on those who pay the tax, however. Producers may be able to pass a part of any tax increase taxes on to consumers by increasing prices, or to employees by reducing wages, and employees may be able to pass a part of any income tax increase on to producers by raising wages. The extent to which such shifting of the tax burden occurs depends upon conditions in the relevant product and labour markets.
It is generally accepted that endogenous growth theory provides a strong presumption that the net effect of taxation is to reduce economic growth as a result, for example, of its negative influence upon innovation and upon the development of human capital. A survey of the empirical evidence has concluded, however, that it does not support that aggregate presumption, although it does throw light upon the effects of some tax instruments..
The effects of individual taxes
Taxes on employment income and compulsory contributions to social security schemes can affect the supply of labour as a result both of their income effect - to the extent that they make employees try to compensate for their loss of after-tax earnings - and their substitution effect - to the extent that they make employees willing to sacrifice their earnings in exchange for the benefits of increased leisure. Empirical evidence tends to indicate that income tax has a negative effect that is larger for females than for males, and that it is greater for both when tax rates are progressive. The combined influence of employment income taxation and means-tested state benefits can also reduce the supply of labour as a result of the operation of the unemployment trap and the poverty traps. Taxes on employment income can also affect the demand for labour as a result of the tax wedge that is driven between he cost of labour to employers and the net payment received by employees. The magnitude of the effect upon unemployment depends upon the price flexibility in the relevant labour market, because it depends upon the extent to which employees are able to pass a tax increase on to their employers . There is also evidence that high tax rates for low earners can increase unemployment among low-skilled employees, especially at relatively high levels of the minimum wage.
The substitution effect of personal taxation may be expected to reduce the motive for saving, but the income effect may prompt an increase in savings in order to preserve a desired level of retirement income. Empirical evidence concerning the magnitude of the net effect has yielded widely differing findings but there is general agreement that the outcome is a reduction in savings. There is also some evidence to suggest that income tax may reduce human capital as a result of its effect upon the willingness of parents to spend money on their children.
The above effects suggest the possibility that high marginal tax rates have negative consequences for productivity, and an OECD study has indicated that progressive income tax does, in fact, cause significant reductions in GDP per head (in addition to any effects arising from the reduced acquisition of human capital), .
There is no apparent advantage to be gained from adding a tax on company profit to its taxation as part of personal income taxation - although it was suggested in the Meade Report that it might be considered to be a payment for the privileges of limited liability. Corporate taxation may be expected to reduce productivity in several ways. It can alter the relative costs of capital and labour in such a way as to move resources into less productive activities. It imposes compliance costs on firms and administrative costs on governments, thereby diverting resources away from productive activities. It may reduce incentives to invest and innovate, and it may impair technology transfer by deterring foreign direct investment. The deductability of interest payments favours established corporations that can readily finance their investments by borrowing at the expense of innovative, knowledge-based and recently established firms that are riskier or less able to provide collateral, so have to obtain most of their funding from shareholders. In fact empirical evidence at the firm level and at the industry level confirms the conclusion that corporate taxation reduces productivity. However, alternative forms of corporate taxation (such as the use of 100% "capital allowances" or the adoption of "flow-of-funds" taxation ) may mitigate some of the above effects.
Taxes on consumption
Consumption taxes do not affect savings because they apply the same rate to current spending as they do to future spending, and a uniform tax on all purchases would not be expected to affect economic activity, except for the possibility that their effect on purchasing power might add to labour costs as a result of wage bargaining. However, no consumption tax effect was revealed by a recent empirical study of the effect of taxation on employment . Consumption taxes are considered "regressive", to the extent that they are levied on goods that account for a relatively high proportion of the spending of poorer families - and exemptions of selected products are sometimes introduced to mitigate that effect.
Taxes on land and buildings may be expected to have relatively little effect upon decisions to supply labour, to invest in human capital, and to produce, invest and innovate; and recent empirical evidence has confirmed that they are comparatively favourable to economic growth. They also have the merit of being cheap to collect and hard to evade. However, taxes on housing, in particular, tend to be unpopular because of their visibility and their effect upon low-income householders; and in some countries there have even been proposals for their replacement by income tax . A tax on gains arising from increases in the unimproved value of land (as recommended in the UK by the "Barker Review of Housing Supply") should not raise such objections, and, by discouraging the practice of holding land out of use for speculative purposes, it could release land for housing and help to stabilise the housing market.
In contrast, taxes on financial and capital transactions tend to reduce productivity and growth. It has been demonstrated that taxes on intermediate transactions are inefficient because the same revenue can better be obtained by taxing income or consumption. The harm that they cause arises from the fact that they discourage transactions that would improve the allocation of resources. For example, capital gains taxes tend to discourage migration to areas where labour is in greater demand by discouraging the buying and selling of houses
The purpose of the environmental taxes that were introduced in the latter part of the 20th century was to prevent the loss of economic welfare that would otherwise result from various forms of environmental pollution. They were supplemented in the 21st century by taxes that were introduced to guard against the danger of the very large long-term economic costs of adapting to global temperature rises of several degrees centigrade. A review undertaken for the British government has concluded that the economic costs of measures to avert that outcome will be substantially outweighed by reductions in the cost of adaptation . A review by economists at the National Bureau of Economic Research has concluded that environmental tax revenues do not significantly alter economic constraints on tax policy, and that environmental taxes need to be justified primarily by the cost-effective achievement of environmental goals.
The effect of the tax mix
Empirical evidence suggests that, as between the traditional sources of tax revenue, corporate taxes are the most harmful for growth, followed by personal income taxes, and then consumption taxes, and that property taxes are the least harmful
The theory of optimal taxation
The theory of optimal taxation provides solutions, on various assumptions, to the problem of designing a tax system that has the best possible effect upon the welfare of the community, taking account of the abilities of its members and their responses to incentives. Its foundations were laid by the Cambridge philosopher, Frank Ramsey, in a 1927 paper and developed by Nobel Prizewinner James Mirrlees  in 1971 , and by numerous academics since then. The practical relevance of many of its findings has been disputed, but they have given theoretical support to proposals to reduce high marginal tax rates for high-earners, to reduce the steepness of tax-rate schedules, to replace excise taxes on selected products with a uniformly-spread consumption tax such as VAT, and to abolish corporation tax.
Modern tax systems had their origins in the 18th century in the United States and in Britain. During World War 1 the standard rate of income tax in Britain rose from 6 per cent to 30 per cent.
Tax revenues in the developed countries now amount, typically, to 30 to 40 per cent of GDP, compared with 10 to 15 per cent at the beginning of the 20th century.
The burden of taxation rose between 1985 and 2007 in all of the major OECD countries except Britain (see the paragraph 1 on the addendum subpage). There are significant exceptions to every other trend, but the OECD's tax database records the following changes in the composition of taxation as occurring in most of its member countries :-
- a fall in the contribution of personal income tax (with exceptions that include Britain and France);
- a rise in the share taken by social security contributions (with exceptions that include France );
- a rise in the share taken by corporate income tax (with exceptions that include all of the larger countries);
- a rise in consumption taxes, accounted or mainly by the spread of VAT to every OECD country except the USA;
- an increase in the proportion of the consumption tax take accounted for by general taxation such as VAT, and a corresponding fall in the share of excise and other specific taxes;
- a reduction the steepness of the increase in tax rates with rising income; and,
- a fall in the highest marginal rates of taxation.
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