Taxes took a quarter of national income in the US in 2012, and on average two-fifth of national income in EU.
Why taxes should figure so strongly in popular music is not clear. Maybe successful popular musicians spends their career writing songs about the things that are most immediate and vital in their lives. When they were young and poor it was love, angst, and perhaps drugs. Once they find themselves on the escalator of fame, wealth, and endless touring, it is the misery of life on the road, divorce, venal managers and their tax bill.
By the 3rd century, it had become necessary to restrict individual mobility, both geographical and social, to ensure that people did not escape the tax obligations they owed by virtue of their occupation or the land that they farmed.
Rapid industrialization and democratization in the 19th and 20th centuries have, however, been associated with a dramatic growth in the sophistication of taxation and in the scale of tax revenues in all industrialized countries. At the end of the 19th century tax revenue was less than 10% of national income in the UK and France, about 7% in the US. During the course of the 20th century, the share of taxation increased roughly by a factor of four.
Old taxes tend to survive even when more modern tax instruments could raise the same revenue more cheaply and efficiently, simply because tax reform carries political risks that inhibit change. New taxes may begin life with clear outlines and a well-defined rationale, but all sorts of idiosyncrasies and complications can be added over time.
This distinction between the contributions paid by employer and employee has little, if any, economic substance. Both components amount to a tax on employment incomes, and their economic impact differs little from income tax.
VAT is levied as a percentage of the value of sales of most goods and services by all forms of business, though in some countries there are exemptions for smaller firms, simply to avoid costs that would be incurred in collecting trivial amounts of tax revenue from a very large number of very small firms.
The USA stands alone among OECD countries in having — so far — resisted the temptations of VAT. Instead, sales are taxed, at state and local level, by a retail sales tax, which applies to sales to retail customers only. Businesses making sales to other businesses as well as to retail customers have to distinguish between the two, and apply the retail sales tax to individual customers, but do not charge the tax on sales to businesses. This “end user distinction” can be a weakness of a retail sales tax, since the decision may often have to be made by a shopkeeper (or till operator) who may have little reason to ensure that untaxed sales are more confined to business customers, and there is little scope for the revenue authorities to monitor the accuracy of these decisions. This vulnerability of retail sales taxes is generally thought to constrain the rates of tax that can be charged, without provoking excessive evasion. Retail sales taxes seem rarely to be charged at rates higher than 10%, while VAT rates of 20% and more are now quite common.
Excise duties were historically one of the main revenue-raising taxes, but have declined in importance over the past century as more modern and powerful broad-based sales taxes have been introduced. Even now, excise duties and taxes on imported goods remain crucial for the revenues of many developing countries, where the organization of economic activity and the limited capacity of government may take complex accounts-based taxes unfeasible.
These major taxes are taxes on business only in a pragmatic sense, in that businesses are simply being used as convenient — and unpaid — tax collectors. In addition, however, two groups of taxes are levied on business in a more substantial sense, in that the amounts that the business pays in tax are related in a more fundamental way to the characteristics of the business and its organization.
In the US and in the EU the revenue from tariffs is now only about 1% of the revenue from other taxes. Elsewhere, however, especially in less developed countries, the significance of tariff revenues can be much greater. For countries with limited administrative capacity, frontier formalities provide one of the few reliable points at which taxes can be charged, and import taxes can make a significant and secure contribution to public revenues. In many countries in Africa, tariffs contribute 20% or more of total tax revenues.
It might be thought that if we levy a tax on a particular group of individuals they would be the people who would bear the burden of the tax. So, if we tax farmers, then it is farmers who are made poorer by the tax. That is far from the truth. The real burden of a tax can be borne somewhere completely different from the location of the legal liability to pay the tax.
The observation that the economic outcome of a tax is unaffected by its legal incidence has some immediate, and rather convenient, implications for policy. It allows us, for example, to choose the side of the market on which to levy a sales tax simply on the basis of administrative cost and convenience. Sales taxes are much more conveniently imposed on the sellers of goods.
The available evidence on the labor supply of men in the workforce suggests that their hours of work vary very little in response to changes in wages.
A further feature of taxes on land — and, for that matter, assets in general — should be noted. Taxes in current and future years are all likely to be reflected in the current price of the asset, since any sale of the asset effectively also hands over to the new owner the liability to pay all future taxes.
The burden of taxes on business does not end up “on business.” Ultimately all taxes on business are borne somewhere else, and ultimately by individuals.
Different readers will no doubt have their own views about the extent to which public policies should seek to redistribute income between rich and poor. This is a matter of moral judgment, a question of “fairness” about which rational, well-informed people may disagree, even while agreeing about facts such as the current distribution of tax burden and the pattern of payments of different taxes.
Some of the regressivity arises because households in the poorest income groups spend more and save less of their income, and some arises when poorer households’ spending contains a higher proportion of heavily taxes items.
However, it is very difficult to understand the impact of taxes without taking into account how they interact with systems of social protection for poor households, the unemployed, disabled, and pensioners.
It is the part of the good shepherd to shear his flock, not flay it.
The operating costs of the IRS are about $40 per head of population; in the UK, $75 per head. In both countries, these operating costs amount to less than 1% of the total tax revenue collected.
Taxpayers incur costs in their interactions with the tax system. For complex taxes, these “compliance costs” incurred by taxpayers can be substantial.
In the US it has been estimated that individual taxpayers spend about 27 hours each year in dealing with state and local income taxes; self-employed taxpayers, 60 hours.
Taxes on goods and services affect product prices and influence what people buy. Taxes on labor income influence how much people work. Taxes on income from savings can influence how much people save, or the form in which they choose to save. Taxes on company profits can influence a whole range of corporate decisions: where the company is based, how its is owned and financed, how much it invests, how much it produces, and how many people it employs. All of these effects of taxes on behavior imply that costs are being incurred int eh course of raising revenue through taxation.
Beside a poll tax, one further tax can potentially raise revenues without incurring a distortionary cost. In the late 19th century, Henry George advocated a tax on land values as the sole basis for financing government. He argued that the high value of land in downtown Manhattan was not created by its owner, but by its location and by the economic activity that surrounds it. Landowners do not earn the rents they receive as a result of their labor and effort; instead, they are passive recipients of value created by others.
The core of George’s argument is that the taxation of land, unlike other taxes, does not jeopardize productive activity; it merely means that some of the rent which would accrue to landowners accrues to the government instead.
Tax policies which minimize the distortionary impact of labor income taxation are generally ones which will sharpen inequality in the distribution of income, and make the least contribution to narrowing the gap between rich and poor.
The least distortionary tax, of course, would not be an income tax at all. A poll tax is effectively the extreme version of an income tax in which the marginal tax rate is set to zero, and the tax-free allowance is large and negative, so that all taxpayers make a single lump-sum tax payment, irrespective of their level of income.
The first is that they affect the interests of different generations differently. Switching from a tax on income to a tax on spending acts to disadvantage older generations relative to younger generations — in particular, the retired who have saved out of taxed income face an increased tax burden on their spending, while for younger generations the tax change makes little difference.
First, and probably most important, are the opportunities that people face to influence the tax that they pay. Many tax systems operate in a way that leave the majority of taxpayers with little scope to evade tax. The tax due on their income is withheld at source by their employer, or by the bank that pays them interest, and they never get their hands on it.
In cases where taxpayers do have control over their tax payments, the extent to which they declare their full earnings and pay all the tax that they should will be influenced by two further groups of factors: their perception of the gains and risks involved; and a complex mix of moral, psychological, and social pressures.
By contrast, nearly all tax systems are much more exposed to tax evasion by the self-employed — people working on their own account, or the owners of small unincorporated businesses. They are in much greater control of the information to be reported; they do not have an employer who may separately report their income to the authorities.
Sales tax evasion, backed up by fraudulent accounting, is likely to be most prevalent in smaller firms where financial matters are held under tight individual control by a single individual owner.
Businesses that engage in aggressive tax planning of this sort can often make a huge return on the resources they invest in fighting legal cases, and they know that in many cases the tax authorities will be unable or reluctant to match their legal weaponry.
Another possible explanation for a high level of tax compliance is that there are significant moral and psychological elements in tax evasion decisions. Some taxpayers may comply, not because they fear detection and punishment, but through a sense of moral obligation or “civic duty,” while others may comply because they care about their reputation in the community, or their own self-image.
Generally taxpaying morality seems to be higher among older respondents — and sometimes amongst the young — than amongst people of middle age, and it tends to be higher amongst those who are religious and amongst women.
Intriguingly there seems to be a tendency for tax morality to be lower among the self-employed.
The obvious first step is in the design of the tax system and tax processes. Designing the tax system so that taxes can, as much as possible, be withheld at source is the single most effective step that can be taken to reducing tax evasion. Taxes can be withheld at source from employment incomes, from bank interest, for company dividends paid to shareholders, and possibly from other payments too.
Tax investigation and enforcement activities are costly.
The logic may be right, but the framework is overly simplistic. One restriction on the penalties that can be levied for any offence of tax evasion is the need to keep penalties in proportion to the scale on the evasion. If severe penalties are imposed for the most trivial offences, there is a risk that they can push evaders towards more, rather than less, evasion. They may well judge that they might as well be hung for a sheep as a lamb, and turn their attention to more ambitious evasion.
The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.
When Smith’s cannons differ from contemporary economics is in their lack of clear guidance about how to balance the various considerations, and in particular what to do when the canons conflict in their recommendations.
Although the economics of taxation is important, and we neglect the economic costs of taxation at our peril, we need to recognize that taxation is first and foremost a political issue. Tax policy is often a major election issue, and short-term political objectives may conflict with long-term rationality. Governments face pressures both from voters and from business lobbyists, and have to balance these pressures and interests in developing their tax policy. The tax system cannot be designed as a purely technocratic issue, and implemented as the outcome of a sophisticated backroom calculation. Ultimately it is the political process that decides on taxes and tax reform.
Proposals for radical income tax simplification are a seductive idea, with considerable political resonance in many countries. Existing tax legislation in nearly all countries is hugely complex — typically many hundreds of pages. Taxpayers struggle to comprehend the system, and often have to fill in long, complex tax returns which they barely understand.
Considerable simplification would be achieved in many countries by eliminating the myriad allowances and deductions which can be set against taxpayers’ income tax.
Many of these have their origins in political and economic pressures in the distant past, but all add to the complexity of taxation, and can create unnecessary loopholes which weaken the revenue-raising effectiveness of the system.
But how realistic is tax simplification? Much tax complexity arises from efforts to prevent the exploitation of tax loopholes.
To avoid erosion of VAT revenues the UK revenue authorities have been forced to defend the tax treatment of various food items: well-paid lawyers have spent days in court debating whether “Jaffa cakes,” a chocolate-coated product, should count as a (zero-rated) cake or a (standard-rated) biscuit. What was at stake was tax revenue equal to 17.5% of the total value of sales: a huge windfall to an individual firm which succeeds in challenging the tax classification.
Zero-rating food helps the poor, but it does so very wastefully: $100 must be spent in order to transfer less than $10 to the poorest 20% of the population.
A further possibility is that what underpins public resistance to imposing VAT on food is not just driven by its effectiveness in helping the poor, but by a wider view that there are some things, such as food, that, in principle, simply should not be taxed. This may well be a principle which would command wide support, but what is clear from the data above is that this view comes at a considerable price.
Countries that try to have a tax system that is more redistributive than elsewhere may find that the losers from this redistribution move elsewhere, leaving only those who might have expected to gain.
Unlike economic competition between firms, which tends to promote efficiency and lower prices to consumers, fiscal competition between countries is not a benign process. Tax havens, in particular, exploit their ability to offer a lower tax regime which undercuts the rates of tax elsewhere; they are not offering any greater efficiency or any other positive advantage, but only the opportunity to sidestep taxes levied elsewhere. Countries which compete to grab tax base from other countries impose a costly burden on other countries, raising their cost of revenue-raising and limiting the range of tax policy choices that countries can make.
Multinationals have the opportunity to shift a significant proportion of their profits into countries where they will be taxed less heavily by manipulating the internal charges — the “transfer prices” — at which they book trades between their subsidiaries located in different countries. Profits can be shifted out of a country where they would be taxed heavily by raising the price which that subsidiary must pay other parts of the group for supplies or the use of IP, such as patents or brand rights, and by under-charging for its own sales within the group.
There is nothing equitable about a tax system in which the mobile — and perhaps predominantly rich — can avoid taxation, while the burden of taxation ends up borne by those unable to escape. Nor is there anything efficient about allowing unrestricted international tax competition to erode parts of the tax base.