Criteria for a Good Tax System
Presented to the Citizen's Commission on Taxation
June 10, 1997
A. Equity or Fairness
Equity is often divided into horizontal and vertical. Horizontal equity means that like taxpayers are taxed alike. Vertical equity means that taxpayers in different circumstances are taxed differently, in an appropriate way. Under either dimension, there are two basic ideas about fairness. Taxes could be set based on people's ability to pay them. Or taxes could be set based on the government services or benefits people receive. Figuring out who actually pays taxes--tax incidence--can get complicated. Statutory or legal incidence shows who receives the tax bill and writes the check. Economic incidence shows who bears the tax burden after accounting for changes in prices and wages made by businesses in response to business taxes. Some taxes are exportable, meaning they are paid by people who live outside the taxing jurisdiction.
1. Ability to Pay
Under the ability to pay standard taxes are set based on measures of a taxpayer's income or wealth. Income is the most common measure of ability to pay. Taxes are labeled progressive when they are an increasing proportion of income as income rises. The Federal income tax rate structure is progressive, since those with higher incomes are taxed at higher rates. Taxes are labeled regressive when they are a decreasing proportion of income as income rises. The social security tax is regressive, because taxes are not collected on income above a certain limit. Taxes are labeled proportional when they are a constant proportion of income as income rises. A flat rate tax without deductions or exemptions would be proportional. Other measures of ability to pay could be wealth or net worth.
2. Services Received or Benefits
Under the services received or benefit standard taxes are set based on the government
services taxpayers consume or the government facilities they use. A gasoline tax with
proceeds devoted to road maintenance is perhaps the tax closest to the benefit standard.
Roughly speaking, those who use the roads pay for their repair. Some benefit taxes might
more accurately be called fees or charges. An admission fee at a public park is an
example; school charges to parents is another.
In Fall 1996 we asked 534 Indiana residents whether they thought taxes should be set based on ability to pay or services received. 74% said ability to pay; 26% said services received. More people who favored ability to pay thought the property tax should be cut by raising a combination of taxes; more of those favoring services received supported raising the sales tax. Two-thirds of those favoring ability to pay thought business should pay property taxes at higher rates than homeowners; only half of those favoring services received thought this. 84% of those who call themselves liberal support ability to pay; 62% of those who call themselves conservative support ability to pay.
Incidence is the answer to the question, "who pays?" Which taxpayers bear the burden of taxes?
a. Statutory or Legal
Statutory incidence measures tax burden based on who pays the tax bill. Homeowners are said to bear the burden of the property tax on their homes; consumers bear the burden of the sales tax on their purchases; businesses bear the burden of the income tax on their profits.
Some business taxes are probably passed forward to customers in higher prices. Some are probably passed "backward" to employees in lower pay and benefits. And some taxes are not passed on, but borne by business owners in lower profits and dividends. If, for example, a property tax hike causes a landlord to raise rents charged to tenants, then at least part of the property tax burden has been passed on to the landlord's customers. The statutory taxpayer--the landlord--pays the tax bill, but the tax has caused higher rents and so is partly borne by the tenants.
When a business tax is first imposed, statutory and economic incidence are the same. The tax cuts into business profits. Businesses look to invest and expand--even relocate--in other locations where taxes are lower and profits higher. Eventually, there are less of the business's products available, so their prices go up. Eventually, there are fewer job opportunities available working for the business, so pay goes down (or goes up more slowly). Sometimes people wonder why businesses care about their taxes if they can simply pass the burden to others in prices and wages. In fact, tax burdens shift because businesses care about their taxes enough to alter their business's locations to avoid them.
Studies of business property taxes in large cities--Chicago, Indianapolis,
Phoenix--show that one third to one half are passed on to customers and/or
employees through price and wage changes. The remaining one-half to two-thirds are borne by business owners through lower profits.
It's often said that the best tax is one that someone else pays. Taxes imposed by one
jurisdiction are sometimes paid by people who live elsewhere. When this happens, the tax
is said to be exported. For example, gaming taxes in Nevada are largely exported, because
most people who pay them are out-of-state tourists. Oil severance taxes in Alaska are
largely exported, because they are passed on to oil consumers who live all over the
country. Taxes on corporations that are borne by stockholders are largely exported,
because most of the stockholders live out-of-state. Hotel-motel taxes are mostly passed
on to customers who live outside the community.
B. Adequacy or Revenue Yield
A tax or tax system must raise the revenue required to support the government services that taxpayers demand. Revenue yield is generated by the application of a tax rate or set of rates to a tax base. A tax base is an economic asset or activity which can be taxed, such as sales, income, profits, or property. A tax's capacity depends on the size of this tax base. Tax effort depends on the level of the tax rates which a government sets. Yield will depend on the size and growth of the tax base, and on the levels of tax rates which taxpayers will accept.
1. Tax Base Growth
How fast will tax revenue grow relative to the state economy? It depends on how fast the tax base grows, and how tax rates are set up. Fewer people are smoking, so cigarette tax revenue is growing slowly relative to the economy. As incomes rise revenues from the progressive Federal income tax tend to rise more. This is because an ever greater share of people are pushed into higher tax rate brackets.
Some think that a tax system's revenue should grow faster than the economy. A ten percent increase in state income should produce a twelve percent increase in revenue, for example. This would allow the government to meet increasing demands for services without the need to raise tax rates. Others think that a tax system should grow at the same rate as the economy, at most. The government would have to pass a tax rate increase every time expanded services were considered, forcing the government and the public to consider their benefits and costs.
2. The Tax Rate Affects the Tax Base
The tax base is usually diminished when a tax is imposed or increased. A tax on property
improvements may discourage construction; a tax on income may discourage work; a tax
on profits may discourage investment; a tax on cigarettes may discourage smoking. This
means that an increase in a tax rate will not yield a proportional increase in revenue. A
government may raise the income tax ten percent, but revenue is likely to rise only eight or
nine percent. Some taxes may diminish their tax bases a lot, others not very much. It's
logically possible for a tax to be increased so much that the tax base could diminish
enough to cause revenue to fall. Real world examples of this are hard to come by,
An elasticity is a number showing the percentage change in revenue produced by a percentage change in something else. An income elasticity shows how much revenue grows due to a one percent increase in income. An income elasticity of 1.2, for example, would mean that revenue grows 12% every time income grows 10%. A rate elasticity shows how much revenue grows due to a one percent increase in a tax rate. Rate elasticities are almost always less than one, because a 10% increase in the rate will diminish the tax base and produce a smaller percentage increase in revenue.
C. Stability or Predictability
Some taxes grow steadily year after year, others fluctuate between rapid and slow growth, or even decline. Government budgets are made in advance of the fiscal year, so predictability of revenues is an advantage. An unexpected shortfall in revenues can cause tax increases or cuts in promised programs; an unexpected windfall means programs that could have been funded were not, or tax cuts that could have been provided were not.
Recessions are declines in economic activity, expansions are increases in economic activity. Recessions tend to cause decline in tax bases and so reduce tax revenues. During a recession more people are unemployed so income tax receipts fall (or grow more slowly). People postpone major purchases of cars, appliances or furniture, so sales tax receipts fall. Many corporations lose money so corporate income tax receipts fall. Housing construction subsides and businesses keep fewer inventories, so property taxes may fall. Some tax bases are more variable than others. Corporate profits vary a lot; the value of real property does not.
Inflation is a general increase in prices. Inflation tends to increase tax bases, and tax
revenue. Some tax bases respond to inflation more, some less. Price increases directly
affect the sales tax base, so sales taxes keep up with inflation. Wage and salary increases
usually keep pace with inflation, hence so do income tax receipts. Property values keep
pace with inflation, but, in Indiana, assessed values do not. Property tax receipts often
will not keep up with inflation without property tax rate hikes.
D. Economic Competitiveness
The economy affects taxes, through growth and stability. But taxes also affect the economy.
1. Incentives for location/investment/expansion
There is now wide agreement that taxes affect business location and expansion. Businesses prefer lower taxes, and will locate and expand where taxes are lower, all else equal. Direct business taxes such as business property and income taxes appear to be especially important. Of course, businesses also respond to individual taxes (on firm managers, for example). And public services such as education, police and fire protection and transportation systems are also important for firm investment decisions.
In the absence of taxes, individuals would make their decisions about spending, saving and
working based only on their needs, wants and talents. Businesses would make their
production, employment and investment decisions based only on their opportunities and
resources. It is thought that these decisions are efficient, in that they produce the greatest
well-being for people given the expenditure of resources. Taxes can distort these
decisions, causing people and businesses to use resources in less efficient ways. As noted
above, taxes on income may discourage work, so the economy will produce less. Sales
taxes on goods but not services may cause people to buy more services than they
otherwise would have. Those concerned with neutrality recommend that governments
choose tax bases that are little affected by the imposition of taxes.
Great Britain experimented with the most neutral tax of all, the "head tax,"
during the 1980s. Every adult was taxed a fixed amount for the support of local
governments. Everyone from the dustman to the Queen paid the same amount.
This tax is neutral because--short of the guillotine-- no one can change their
behavior to avoid it. Changing investment, employment or spending decisions
has no effect on the tax paid. Thus, it is thought, people will make efficient use of
their resources. The tax didn't last long. It was attacked mainly on equity
Ever since 19th century American economist Henry George, analysts have pointed
out that a tax on land could be neutral. Land cannot be relocated. As long as the
tax does not depend on the use to which the land is put, decisions on land use will
not affect the tax payment, so the decisions will be made on efficiency grounds.
In the past ten years Pittsburgh, Pennsylvania has altered its property tax so that
it taxes land at higher rates than improvements.
3. Sumptuary Taxes
Sometimes governments use taxes to discourage activity that makes up a tax base. These are called sumptuary taxes. Taxes on cigarettes and alcohol are sometimes justified because they discourage smoking and drinking. One of the benefits often cited for a national consumption tax is that it should discourage consumption and increase saving, which could add to economic growth.
High tax rates probably cause more distortion to people's decisions than low tax rates,
perhaps increasingly so. A balanced tax system, with many taxes at low rates, may cause
less distortion than a system with a few taxes at high rates.
E. Administrative Efficiency
Taxes are costly to collect, and some are more costly than others.
1. Public Cost
Costs of revenue collection to the government include pay of employees and the equipment they use for keeping track of taxpayers, preparing forms and instructions, valuing the tax base, calculating the tax owed, accounting for revenue received, and handling appeals. Enforcement of a tax requires notifying taxpayers of the rules for payment, and identifying, apprehending and prosecuting tax delinquents and evaders. The cost of enforcement rises the higher is the tax rate, and the more complex are the rules defining the tax base.
2. Private Cost
Some taxes are costly for taxpayers to pay. These are sometimes called compliance costs.
Taxpayers must keep track of transactions and income sources. For some taxes they may
hire accountants and tax preparers. If they disagree with the government's assessment of
taxes owed, they may have to file and follow through with an appeal. Some of these costs
are in money (the tax preparer's fee), others are in time (the evenings spent with the 1040
form instead of playing with the kids).
The property and income taxes have contrasting public and private costs. The property tax has high public costs but, for most taxpayers, low private costs. Every parcel of property must be assessed by a government assessor, and its record kept on file in a government office. On the other hand, many taxpayers with mortgages never see a tax bill, and instead pay taxes monthly along with the mortgage payment. The income tax has relatively low public costs but high private costs. The IRS is a big, expensive agency, but not compared with the billions the income tax brings in. It's size is dwarfed by the national industry of tax attorneys, accountants, and preparers. Add to this the value of the hours of time each of the millions of taxpayers puts in each year, and the private costs of the income tax exceed the public cost by many times.
Some analysts think it is important for taxes to be visible, that is, for taxpayers to know when they are paying and how much. It may be that complex tax systems, with many tax bases and rates, obscure the full cost of government for taxpayers. If taxpayers are to participate in the debate about the costs and benefits of government programs, the argument goes, they must know the size of their tax bill.
Some of the national flat tax proposals of two years ago advocated eliminating income tax withholding. The concern was that withholding made the income tax less visible. Taxpayers never see the money they pay in taxes in their paycheck. Many may think of April 15 as the day they get money back for the Federal government. Ending withholding would increase visibility, but would probably increase the cost of enforcement.