AlMoatassem MostafaLecture Six: Sunday, 13 November 2016

TAXATION & TAX LEGISLATION

Essay Two: Tax Policy &

Tax Legislation

Definition of Tax Policy &

Tax Legislation

Principles of Tax Policy

Tax Compliance

Principles of Tax Policy A Historical Background Contemporary Principles

LECTURE OUTLINE

In any contemporary tax systems, certain principles must be considered during the process of designation of tax policy. Principles of taxation are those guidelines that are universally accepted and must be taken into consideration during the formulation and implementation of tax legislations.

Lead economists, including Adam Smith, have proposed a number of principles that must be followed and considered for a tax system to be “ideal”. These principles have laid the foundations for the principles followed by most tax systems today.

PRINCIPLES OF TAX POLICY

ADAM SMITH’ WEALTH OF NATIONS

Lead economists had proposed a number of principles for an “ideal” tax system. In his famous book “Wealth of Nations” 1776, Adam Smith proposed four main principles of taxation in the second chapter of Book V as follows:1. A tax should be based on the person’s ability to pay. Therefore, the

contribution of taxpayers towards their states must be proportional with the revenue they receive;

2. Taxes must be certain not arbitrary. Tax systems must be clear in terms of payment method, time of payment, and quantity paid. Taxpayers, therefore, must not be subject to the tax authority’s arbitrariness that might result in extortions of taxpayers;

3. Taxes must be convenient for the taxpayer in terms of its time and method of payment; and

4. Taxes must be administratively efficient and must not cause any economic distortion. This means the tax collection process must not result in significant costs. In addition, taxes must not distort the behaviour of taxpayers, including their ability to save, consume, or invest.

TAX PRINCIPLES: A HISTORICAL BACKGROUND

Contemporary

Principles

Equity Certainty & Simplicity

Convenience Efficiency Neutrality Flexibility

CONTEMPORARY PRINCIPLES

The principles of taxation proposed by Adam Smith are regarded as the foundations for the principles that govern majority of modern tax systems worldwide.

In summary, the contemporary principles of taxation include equity, certainty and simplicity, convenience, efficiency, neutrality, and flexibility.

CONTEMPORARY PRINCIPLES

A tax system must be equitable and fair. It is important in this regard to differentiate between horizontal equality and vertical equality. Horizontal equity means that taxpayers in similar circumstances should bear a similar tax burden.

Vertical equity, in contrast, addresses the question of how people at with income levels should be taxed. Vertical equity, therefore, suggests that taxpayers with higher incomes should bear a larger tax burden as a proportion of their income.

Direct taxes that enforce progressive tax rates conform to the notion of vertical equity, while indirect taxes, including sales tax for instance, conform to horizontal equity.

EQUITY

A tax system must be certain, clear, and simple to comprehend by taxpayers. In this sense, payment method of tax, time of its payment, and quantity paid must be clearly understood by taxpayers.

These features are particularly important because they make it easier for individuals and businesses to determine and understand their tax burden. A certain and simple tax system is essential for business planning since businesses plan their costs, including taxes, in advance.

It is also an important determinant for investment in an economy. Consequently, businesses are more likely to make optimal decisions and respond to intended policy choices in the light of a simple and certain tax system.

CERTAINTY & SIMPLICITY

Convenience of taxation is a direct consequence of its simplicity and certainty.

Taxation must be convenient in terms of the time and method of collection.

For instance, contemporary tax systems require that taxes must be paid in cash. In-kind payment of taxes (as the case with old tax systems) is no longer required by tax systems, as it is an inconvenient method of tax payment.

In addition, most tax systems worldwide require that taxes, especially direct ones, be collected once every year. Taxpayers are required to prepare and submit their annual tax return before the tax due date.

CONVIENCE

A tax system is regarded as efficient if compliance and administration costs of taxes are minimized as compared to revenues resulting from taxes.

In this regard, the efficiency of a tax system is not related solely to the cost incurred by tax administration. It is also based on the cost incurred by taxpayers to comply with the tax.

In developed countries, the cost of collecting taxes is low as compared to developing countries where the costs of tax collection may be substantially high.

EFFICIENCY

A tax system is said to be neutral if it does not result in distortion of economic choices and excess burden of tax.

Taxes should aim to secure revenues and to guarantee an optimal allocation of the means of production without encouraging or discouraging certain economic choices.

Taxes cause distortions in economic choices if they result in changes in supply and demand of certain goods, for instance.

Most contemporary tax systems are not completely neutral. Sometimes governments aim to discourage the supply and/or consumption of certain goods by taxation. This can be visible in discouraging the consumption of demerit goods through taxation.

NEUTRALITY

Taxation systems should be flexible to adapt to the ongoing changes in the economies.

Flexibility of taxation systems is additionally required since the size of revenues needed for governments is continuously changing.

To avoid confusion in this context, flexibility does not imply a continuous change in tax systems, since the stability of a tax system is highly essential. Flexibility means that despite the stability of the structure of a tax system, tax policy could be subject to ongoing adjustments based on changes that economies undergo

FLEXIBILITY