Antonio PEdone WP119

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WORKING PAPERDIPARTIMENTO DI ECONOMIA PUBBLICA

Working Paper n.119

Antonio Pedone

Tax Theory and Tax Practice:

The Problems of Defining, Measuring and Assessing Tax Bases

Roma, Maggio 2009

UNIVERSITA DEGLI STUDI DI ROMA

LA SAPIENZA


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TAXTHEORYANDTAXPRACTICE:THEPROBLEMSOFDEFINING,MEASURINGANDASSESSINGTAXBASES*

AntonioPedoneSapienzaUniversityofRome

Abstract

Thewidegapbetweentaxtheoryandtaxpracticemaybetracedback,amongother

things, to the focus in tax theory on the level and optimal structure of tax rates,

assumingthattaxbasesareconsistentlydefined,preciselymeasurableandreadilyand

uniformlyassessable.Thisapproachoverlooks thevariancesbetween taxdesign, tax

law,taximpact,taxincidenceandtaxperception.Theeffectsoftaxesonefficiencyand

equitydependnotjustonthetaxratescheduleadoptedbutalsoondifferencesintax

treatmentsresultingfromthedefinition,measurementandassessmentoftaxbases.

The Italianexperience in the fieldof income taxationshows theextent towhich the

definition, measurement and assessment of tax bases matter. Many problems

associated with defining, measuring and assessing tax bases, which the personal

nature and high progressivity of income tax had contributed to highlighting and

accentuating, remain still unresolved and require further research of a better

understanding of the rationale, causes and effects of many differentiated tax

treatments.

Keywords:taxtreatment,taxdesign,personalincometax,taxassessment

JELcodes:

H20,

H24

* This paper is a revised version of an invited keynote lecture given at the 20th

ScientificMeetingof theSociet ItalianadiEconomiaPubblica (SIEP) inPaviaon25September2008.

Correspondenceto:[email protected]


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1.IntroductionTheeconomicsof taxation isanarea inwhich there isaverywidegap,

particularlyinItaly,betweentheoreticalandeconometricanalysis,ontheonehand,andtherealityoftaxpolicyandpractice,ontheother.

It couldbe that theobserveddividebetween tax theoryandpractice is

onlyapparentandthatKeynesgeneralremarks1regardingtheunwitting

influence,forbetterorforworse,oftheideasofeconomists,applyinthis

case.ItmaybethatthetraditionalItaliantendency,notedbyBuchanan2,

offocusingattentionontheoreticalaspectswhilstneglectingissuesoftax

reform, is stillwidespread and prevalent among scholars in the fieldof

public finance. Itmight perhapsbe that,on theonehand, the growing

specialisationandrefinementofthetheoreticalandempiricalanalysisof

various aspects of the economics of taxation and, on the other,

continuous changes in an increasingly complex economic and social

reality, make it difficult for tax theorists and tax practitioners to

communicatewitheachother(eventhoughafrankexchangeofopinions

couldperhapsproveusefultoboth).Yetitcouldalsobethat,as inother

fieldsoftheoreticalandappliedeconomicresearch,analyticalmodelsand

econometric estimates provide ambiguous findings and mixed results,

whilsttaxpractitionersexpectunequivocalandpracticablepropositions.

Thefactis,however,thatagapbetweentheoryandpracticedoesexist

andquiteawideoneatthat.Intaxationtheory,thefocus isonthe level

and optimal structure of tax rates, assuming that tax bases are

consistently defined, precisely measurable and readily and uniformly

assessable.

In reality, when moving from theoretical models to the concrete

applicationofany formof taxationdeemedoptimal, it isalmostalways

thecasethattheeffectsproducedintermsofefficiency,equityandother

significant economic variables are different from the effects anticipatedon thebasisof the theoreticalmodel.Themore thatcertainconstraints

varyandaresubjecttochange from theway theyare formulated inthe

theoreticalmodel,thegreaterthedifferencebetweenthetheoreticaland

practicaleffects.

Each of these constraints namely, the prevailing social and economic

structure,thedegreeofinternationalintegration,institutionalsetups,the

mannerinwhichthetaxadministrationisorganised,andtheattitudesand

behavioursoftaxpayersmaybeapproximatedbyasetofindicatorsthat

aremoreorlessrepresentativedependingontheavailabilityofdataandexperiencestodrawon.Theirrelative importancealsovaries indifferent


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circumstances,asdo theways inwhich they interact.These constraints

areoften ignoredor inadequately considered inmany current analyses,

which assume the existence of welldefined and consistently and

uniformly measurable and assessable tax bases, thus focusing research

effortsonoptimaltaxrateschedules.However, it is my belief that the discrepancy between the anticipated

theoreticaleffectsandtheactualeffectsproducedisnotonlytheresultof

theapplicationoftaxrateschedulesthatdiffer fromthosesuggestedby

theory,but the consequence, above all,ofdifferences in thedefinition,

measurementandassessmentoftaxbases.Thesedifferencesdependon

theabovementioned fivegroupsofconstraintsandchanges inthem in

otherwords, on their actual configuration and development in a given

countryduringagivenperiodoftime.Asaresult,taxrelatedanalysesand

proposalsthatdonottakethesefactorsintoaccountandarebasedsolely

on findingsdrawn from inevitably aggregated and simplified theoretical

modelscanbemisleading.

Iwillseekheretodemonstratethebasisforthisassertion,brieflyrunning

through certain aspects of the Italian experience with regard to

comprehensive progressive personal income tax (CPPIT), although the

same reasoning could be applied to other taxes such as consumption

taxes. The reference made to the Italian experience is only by way of

example.Itisnotintendedasadescriptionmuchlessanappraisalofthat

experience,but rathersolelyasameansofdrawingattention toseveral

points which highlight the importance of defining, measuring and

assessingtaxbases(inthiscase,income) inanalysingrelationshipsand

thegapexistingbetweentaxtheoryandtaxpolicy.

2.TheoriginsofthegapbetweentaxtheoryandtaxpracticeInverysimplifiedterms,thegapbetweentaxtheoryandtaxpracticemay

be tracedback tovariancesbetween ideal taxation (taxdesign), legallyimposed taxation (tax law), the effective impact of taxation (in otherwords,who is formally liable to pay the tax: tax impact), the effectiveincidenceoftaxation(namely,whoultimatelybearsthetax:taxincidence)andperceivedtaxation (ortaxperception).Byclarifyingthe issuesraisedbyeachofthesephasesandtherelationshipsbetweenthem,itispossible

togainanideaoftheextenttowhichtheoreticalindicationsandconcrete

applications of a given form of taxation coincide or deviate, and tocompare the effects anticipated by the theoretical model (in terms of


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revenueyield,efficiency,equity,income,stabilisationandgrowth)andthe

effectsthatareactuallygeneratedinaspecificeconomicandinstitutional

systemofagivencountryduringagivenperiodoftime.Beforeexamining

how,intheItaliancase,thesevariousphasesandthetransitionfromone

phasetothenexthavebeen influencedbythevaryingdegreeofpriorityaccordedtodifferentobjectivesandthevaryingstringencyofthedifferent

constraints, it isworthmentioninga fewgeneral issues thatariseduring

eachphasewhenthetaxbaseinquestionisincome.

Evenatatheoreticallevel,thereisnouniformapproachtothechoiceofa

taxbasethatisincomebased.Thethreeincomeformulationsgenerally

referredtonamely,incomeasproduce,incomeasearningsandincome

asconsumptionorexpenditurecaneach includedifferentcomponents

dependingon the timeframeandon theaccountingstandardsand face

valueinflationadjustmentcriteriaadopted3.Moreover,onceagainatthe

theoretical level, it is possible to arrive at alternative definitions of

scientificimportancewhichshouldbekeptquiteseparate4.

The distinction that it is advisable to maintain between the different

theoretical definitions of income that may be used (and are used in

models)asataxbaseforincometax,shouldalsobeaccompaniedbyan

awareness of the remarkable difference between the meaning (or

meanings)ofincome,asthenotionappearstotheeconomictheorist,and

themeaningwhichisgiventoit,whichindeedhastobegiventoit,when

incomeisconsideredasanobjectoftaxation5.

It isnotmy intentionhere toenter into thedebate regarding themost

appropriateoroptimumtheoreticaldefinitionofincometoadoptasthe

base for a comprehensive progressive personal income tax6, partly

becausetheproposalsputforward inrelationtothetaxbasefor income

taxhavealways,and toagreaterextent in recent times,beenmixedor

hybridinnature.Itisenoughtoassumethatsomedefinitionofincome,

whether pure or hybrid, has been formulated and adopted as the

theoreticaltermofreferenceofaCPPITtobeleviedinagivencontext.

3. DifferentiatedtaxtreatmentsWhatever the theoretically preferred tax base definitionmight be, it is

unlikely that it will be legislatively adopted in identical form. Indeed,

normally thisdoesnothappen for themajorityof taxesexcept in some

verysimplecases,suchasexciseduties. In thecaseofmany income tax

systems, including that in Italy, there isactuallynogeneraldefinitionof

incomeintaxlaws.Instead,categoriesofincomearelisted(ofwhichthere are 6 in Italy), each with their own rules. Often, they are also


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considerablydifferentiated,evenwithin individualcategories, intermsof

the definition of tax bases, the criteria for theirmeasurement and the

methodsusedtoassessthem.

In this way, already at the tax law level, a very large number of

differentiated tax treatments (DTTs) is created consisting of variousexclusions,exemptions,deductionsandallowancesapplicabletodifferent

types of incomeproducing activity and to the most varied of personal

circumstances (whether of individuals or businesses), as well as being

differentiatedaccordingtothevarioussourcesofincomeandthevarious

usestowhich income isput.The inextricablemessoftax legislationthat

results, made up of innumerable DTTs that are often inconsistent and

uncoordinated,providesampleopportunity for taxarbitrage. Inorder to

addresstheoverexploitationofsuchopportunitiesandtheproliferationof

new forms of avoidance transactions, especially of a financial nature,

there is a constant need for legislative amendments and regulatory

innovations,whichbecomeincreasinglymorecomplex,difficultandcostly

tomanagefortaxauthoritiesandtaxpayers.

Inmovingfromtaxdesigntotax law,thetheoreticalconceptsof income

arebrokendownandmixed together inavastarrayof legislation, from

which it is no longer possible to distil any clearly identifiable and

consistent common guiding principles. Legislative output aimed at

combating the continual development of new forms of avoidance

transactionsgrowsever larger andmoredetailed.Added to this, rather

than as an alternative, recourse is alsohad to general substanceover

formrules,suchas thoserequiringverificationoftheactualnatureand

economic content (or economic substance) of such transactions,

regardless of how they are framed formally. These are rules that are

complex to interpret and difficult to apply for tax officials that are not

alwaysadequately trainedand skilled.Theirapplicationmay require the

assistanceandopinionofeconomists(ashasoccurredforsometimenow

intheantitrustfield)andawillingnessontheirparttotalkandcooperatewith legal professionals who use different language, methods and

principles.

Asthemuddleoflegislationgrowsincreasinglyconfused,resorttocourts

of lawandjudicialinterpretationbecomeunavoidable inmanycasesand

playarolethatisnolongernegligibleintheverydefinitionofthenature

andscopeoftaxbases7.

Inmany countries, recentdecadeshave seen repeated callsand several

reformproposalsforthesimplificationoftax laws,thereductionofDTTs

andawideningofthetaxbase.Theresultshave,however,beenmodestand temporary in nature, because tax law is influenced by factors that


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have only been partially examined and which greatly contribute to its

further complication by increasing the resort to DTTs. These factors

include:thecharacteristicsofthedecisionmakingprocesswithrespectto

taxlegislationandtheroleplayedinthatprocessbybureaucrats,political

parties, parliamentary bodies and rules, and organised interest groups;the objective complexity and the continual transformation of the

economic and financial situation; and the use of DTTs as a means of

obtainingconsensusandexploitingpoliticalrents8.InItalytoo,occasional

effortstorestoreneutrality,includingwithinspecificcategoriesofincome

(for instance, between various types of investment income or between

various typesofbusiness income),orhorizontalequitybetween specific

categoriesofworkers(forinstance,betweenthosereceivingincomefrom

employmentand thosewhoareselfemployed),haveessentiallybeen in

vain and, in some cases, counterproductive. The tax laws that resulted

fromsuchattemptshaveoftenbeenevenmorecomplicated than those

thatpreviouslyexisted.

4.ImplementingtaxlawsRegardless of how complicated tax lawsmay be, they also need to be

applied by tax officials and taxpayers (often with the assistance of tax

advisors).Thephaseinvolvingenforcementoftaxlawsbyauthoritiesand

themoreorlesswillingandfullcompliancebytaxpayersisanothercrucial

stagewhere thegapbetween tax theoryandpractice tends tobecome

wider9.

Indeed,theDTTsprovidedforbylaware,inturn,appliedinamannerthat

is not uniform but rather differentiated according to the different

assessmentmethods employed and depending on the behaviour of tax

officials, taxpayers and tax judges. The extent and methods of

implementationoftaxlaws(andtheDTTstheyprovidefor)areinfluenced

by numerous factors that have been the subject of a wide body ofliterature which examines: the resources, competence, organisation,

proceduresandincentivesoftaxofficials;theeffectivenessofthepenalty

system and litigation proceedings; and the strategic behaviours of

taxpayersandtheroleoftheirtaxadvisors.Idonotintendtorecallhere,

notevenbywayofsummary, theproblems identifiedand the solutions

proposed and adopted in respect of each of these aspects.What is of

interesthereistonotethatthevarioussolutionsformulatedintheoryor

adopted in practice to address each of these issues involvesDTTs that

become evident when examining who effectively pays (though notnecessarilyultimatelybears)thetaxesinquestion.


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Itisstillamatterofdebateastowhether,inordertoassesstheireffects,

itisbettertoconsidertheimpactoflegallyimposedtaxratesoreffective

(averageandmarginal)taxrates,andhowthelattershouldandcouldbe

calculated.Forourpurposes,itisenoughtonotethatreferringtooneor

the other produces very different results depending on the variouscharacteristics of individual types of incomeproducing activity and

taxpayers. In many cases, effective tax rates represent average values,

whoseaggregated trendscanconceal thenonuniformandsometimes

conflictingpatternsofindividualcomponentsintermsoftaximpact.

Turning to consider effective tax in terms of incidence (rather than

impact), it becomes necessary to introduce specific assumptions about

shiftingthetaxpaidbythetaxpayer.Alongsideuniformzeroortotaltax

shifting, frequentlyused fortheirexplanatorysimplicity inmanymodels,

theadoptionofdifferentiatedshiftingofthetaxleviedonevenasimple

taxbase(suchaswages,orincomefromworkasawhole)givesrisetoa

redistributionof income tax that isdifficult tograspand iscertainlynot

referabletoanyreasonablecriteriaofjustice10.

Finally, it shouldbe recalled that taxeswith the same incidence canbe

perceived differently and that it is taxperception, often in conjunction

withtheperceptionofotheraspectsofpublicaction,that influencesthe

behaviour of taxpayers and their views on the fairness of a tax11.

Moreover, the perceived justice and acceptability of income taxes

dependsinlargemeasureontheextentandcharacteristicsofDTTs,which

reflect differentiations linked to the definition, measurement and

assessment of the various types of income, as we will see when we

examinecertainaspectsoftheItalianexperienceinthisfield.

5.TheissueofprogressivityBefore considering the Italian experience in the income tax field to

demonstrate the extent to which the definition, measurement andassessmentofvarioustaxbasesmatter,Iwouldliketopointoutthatthe

personal and progressive nature of CPPITs complicates any analysis of

thoseissues,whichalsoapplyinthecaseofrealandproportionalincome

taxes.

Progressivity,whichentailsaconsiderationoftotalpersonal income,has

beenjustifiedinmanywaysthatcanmoreorlessbeanalyticallyexamined

andcategorisedintermsofsomeconceptorotheroftaxpayingcapacity.

Onejustification,thatbylongstandingtraditionhasbeengiven,isthatof

not imposing unduehardshipon taxpayers thatwould force a cut insociallydesirableconsumption

12.Thus,inordertoguaranteeaminimum


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levelofdisposableincome,aflattaxwithahightaxfreeallowancemight

suffice(althoughwhetherthisshouldbedifferentiatedandonthebasisof

whatcriteriaisunclear).

However, for progressivity above an exempt income threshold, it is

necessary to envisage some relationship between income patterns andtaxpaying capacity patterns, based on some form of utility sacrifice

principle. Indeed,at least intheUnitedStates,thecountrywhereformal

progressivity of personal income tax reached its highest levels (at the

beginningofthe1950s,themarginaltaxratewas94%),thisapproachto

progressivitywasadopted rather thanrelyingonabstractprinciplesas it

wasdeemedthemosteffectivemeanstoreducetheinequalitiesthatare

inevitably created in a market economy. Despite being aware of the

disincentive effects created (to be reduced to a minimum without

compromising progressivity visvis individuals), this approach to

reducing inequalities was still viewed as the least damaging to the

functioning of a market economy compared to other forms of public

intervention,suchasprotectionismorpublicownership13.

However,inordertofunctionandbeequalized,aprogressiveincometax

mustbeproportionaltothetaxpayerstotalnetincomefromallsources,and individual income components must be measured in a uniformmannerforall incomecategories (italicsadded)

14.Thisproposition was

reiteratedby themoststaunchdefenderofCPPIT:Theeffectivedegree

ofprogressionof the income taxdependson thecomprehensivenessof

the taxbaseaswellason the tax rates15.Yet,asnoted, themeasures

proposedandadoptedtowiden thetaxbase,bydetermining itsvarious

componentsinauniformmanner,havenotprovedsuccessful.

Thus itwas that alongside theevidentoriginaldifficulties, linked to the

different measurement and assessment of tax bases and to DTTs

introduced to mitigate the disincentive effects, further difficulties

emergedasaresultofincreased internationalintegrationandchanges in

technology and in production structures. In order to counter thedisincentiveeffectsofhighmarginaltaxratesandthedistortiveeffectsof

theproliferationofDTTs, formalprogressivitywas considerably reduced

more or less across the board (as in the case of the Flat Tax or Dual

Income Tax) and a largely illusory attempt was made to significantly

broadenthetaxbasebyreducingDTTs.

Hence,inItaly,justasinnearlyallindustrialisednations,personalincome

taxcontinuestobethepredominantsourceofgovernmentrevenue,but

themain purposes that facilitated itswidespread adoption in nearly all

countries after the Second World War (including the reduction ofinequalities and automatic income stabilisation) have both in formal


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and, above all, practical terms gradually abated. The effectiveness of

personal income taxhas been greatly reduced and its tax base is very

narrow, confined essentially to income from work and pensions16.

Traditional issues, such as the use of averaging systems for fluctuating

incomes, the tax treatment of income accumulated over a number ofyearsandpaidasa lumpsumandformsofcompensationforfiscaldrag,

mayhavelosttheirsignificanceintheoreticalanalysisbutstillmeritsome

attentiononapracticallevel.Detailedanalysesoftaxrateschedules,also

taking intoaccountsome formsofpublic familysupport,ordealingwith

theextentof the redistributiveeffect,almostexclusively refer to labour

incomeanddonotaddress theproblemofoverall inequalities that,not

justinItaly,areontheincrease(inrelationtowhich,perhapsitwouldbe

worthwhiletocomeupwithsomenewvirtuoustax insteadofthemore

extensivedirectpublicinterventionmeasuresthathavebeenproposed).

The reduction of the level of progressivity has alleviated the inevitable

distortions linkedtothepersonalnatureof incometax,whichrequiresa

choiceoftaxunit(suchasindividualincome,combinedfamilyincome,or

weightedfamilyincome).Wherethereisahighlevelofprogressivity,the

choiceof taxunit canhavevery significant consequenceson the labour

market and the structure of consumption, aswell as on the pattern of

interpersonalrelationshipsandonsocialorganisation. Inpractice,efforts

totakeintoaccountthedifferentsizesoffamiliesandthediversetypesof

incomeearnedbythevariousfamilymembershave ledtoan increase in

thenumberofDTTslinkedtotheseaspects.

Although they have been alleviated by recent tendencies towards

reducingprogressivity,theproblemsassociatedwithdefining,measuring

andassessingtaxbases,whichthepersonalnatureandhighprogressivity

of income taxes had certainly contributed to highlighting and

accentuating, remainunresolved. In fact, in the caseof taxeswith rates

that remain uniform and constant despite variation in the size of tax

bases, it becomes immediately evident that the differentiation in taxtreatment between different taxpayers or types of incomeproducing

activity does not solely depend on disparities in tax rates, but also on

differences in thedefinition,measurementandassessmentof taxbases.

The significanceof these issuesemerges clearlywhen theexperience in

ItalyfollowingtheintroductionofCPPITisconsidered.

6.ThepersonalincometaxinItalyThetaxreformthatwasadoptedinItalyin197374withtheintroductionofCPPIT (or IRPEF, the acronymbywhich Italyspersonal income tax is


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known)ledtoanunprecedentedtransformationofthetaxsystemafull

blownfiscalcataclysm17.Duringthethirtyyearperiodfollowingthefull

implementationofthetaxreformbetween1975and2005,theincreasein

theoveralltaxburdeninItaly(includingsocialsecuritycontributions)was

around three timeshigher than theaverage forOECDcountries (16%ofGDPinItalyasopposedto6%).

During the same period, fiscal pressure in the strict sense (that is,

excluding social security contributions) increased in Italy by 15 points

comparedtoanincreaseoflittlemorethan3pointsintheOECDaverage

andintheEU15membercountries.InothercountriesoftheGroupof7,

during the sameperiod, fiscalpressure in the strict sense fell slightly in

Germany,theUnitedStatesandCanada,remainedessentiallyunchanged

in the United Kingdom and rose a little in Japan and slightly more in

France18.

The increase inthetaxburdeninItalyoverthelastthirtyyearsmaythus

be consideredasexceptional compared to the trendexperienced in the

majority of other industrialised nations, and, in many cases, as

constituting a countertrend. This point should be kept in mind, even

though to a large extent the increase saw Italy closing the gap on the

EuropeanandOECDaverages,whichithasnowdecidedlyexceeded.

Inaddition to the intensityand speedof this increase in fiscalpressure,

mainly concentrated between 1975 and 1995, themeans bywhich this

increase was brought about is worth noting, with around half of the

extraordinary increase in theoverall tax takeattributable toprogressive

personalincometax.InthecaseofItaly,theincreaseinrevenuefromthis

tax in GDP terms has, in the thirty years following the reform, been

greaterthanthat inallthecountriesoftheOECDzone.Duringthesame

period, theaverage forallEuropeancountriesandtheaverage forother

OECD country groupings experienced an essentially steady or slightly

reduced incidence of CPPIT, while a significant reduction was seen in

countries like Germany, the United Kingdom and Sweden (the latter,however,startedfromandremainsataconsiderablyhigherlevel).

Thisincreaseledtoaradicalandunexpectedchangeinthecompositionof

the tax revenue? in the years immediately after the reform came into

effect. While in 1970, direct taxes represented 28% of total taxes and

indirect taxes accounted for 72%, by 1979 the situation had already

almostbeen reversed,with theproportionofdirect taxes (51%) in that

yearexceedingalbeitmarginallythatofindirecttaxes(49%).Thistrend

continuedtogainstrengthovertimeandpersonalincometaxassumedan

increasinglymoreprominentrole.


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Severalconclusionscanbedrawn from theseobservations.Firstly,atax,

even if good in theory, comes up against insuperable limits in practice

when it iscalledon to fulfilpurposes thatare toowide,andparticularly

when itproducesanextraordinaryandunevenratherthanamoderate

andconstantincreaseintotalrevenue.Furthermore, these limitsareevenmoreevidentwhenan individual tax

contributes almost singlehandedly to an exceptional increase in total

revenue19.Itshouldberecalledthat,atthetimewhenthereformpackage

wasbeing formulated, itwasproposed thatCPPITbeaccompaniedbya

netwealthtaxand, inparticular,byabroadbasedconsumptiontax.The

widespreadandsuccessfulopposition to this latter formof taxationwas

based not on theoretical analyses of what in abstract terms was the

preferabletaxbase,butonconsiderationsspecifictothecountryandthe

time. In particular, reference was made to the excessive burden

imposedby indirect taxesupuntil themid1970s and to the associated

emergence of smuggling and tax avoidance practices. The purported

regressivityofsuchtaxeswasalsoemphasised.Intheend,itwasdecided

not to increase indirect taxes given the operation of wageindexing

mechanismswhichwould have exacerbated their impacton prices at a

time when inflation was already high. Whatever the reasons for this

choice,andhoweverwellfounded theywere, it shouldbe recalled that

oftenthefairnessofataxisnottobejudgedinisolation,butinrelationto

other taxes within the system and the actual configuration of the

previouslymentionedconstraintsinaspecificsituation.

7.LessonsfromtheItaliantaxreformThesharpriseinincometaxrevenuethatoccurredimmediatelyafterthe

introductionof IRPEFwasmainlyattributable to three factors thatwere

not accuratelyanticipatedandwerenot readily foreseeable in termsof

theireventualmagnitude.Thefirstofthesefactorswastheimmediateandextensivewideningofthe

pool of taxpayers. The number went from 4,800,000 taxpayers of the

supplementary tax (a kind of surtax levied in addition to the schedular

taxes on income that applied in Italy before the reform) in 1973, to

22,753,000IRPEFtaxpayersin1974.Achangeoftheseproportionscannot

merelybeconsideredinquantitativeterms,astheextendedapplicationof

income tax to a large number of taxpayers also has qualitative

consequences inthat it: increasesthenumberofpersonalcircumstances

thataredifferentiated inmanyrespects; increasesthedemand forDTTs,andprobably the frequencywithwhich theyaregranted,withnegative


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consequencesonvoluntarycompliance,whichisanecessaryprecondition

for the smooth functioning of a mass taxation system; requires the

adaptationoftheresourcesandworkingmethodsoftaxauthorities,with

theadoptionofselectiveand,inmanycases,indirectauditmethods;and

makestheintroductionofreformsorevenpartialchangestoCPPITmoredifficultbecauseof thepossessionby thesametaxpayereven insmall

amountsofdifferent typesof income (for instance, income fromwork

and income from property), which triggers a kind of intrapersonal

distributiveconflict thatparalysesattempts tochange the tax treatment

ofvarioustypesofincome.

Thesecondfactor,whichisparticularlysignificantforthepurposesofthis

discussion, is the introduction of new methods of tax assessment and,

above all, of tax collection, including the extension of withholdings at

source, formsofselfassessmentand thepaymentof tax instalmentson

account.Someoftheseinnovationswereveryeffectiveinsecuringahigh

andregularflowoftaxrevenue,butbecauseoftheirvariedapplicationto

differenttypesofincome,theyactuallyaccentuatedthedifferentiationof

taxtreatmentsofsuchincome,duealsotothemethodsusedtochecktax

returns,theconductingoftaxauditsandtheimpositionofpenaltiesbytax

authorities.

The third factor which contributed to the extraordinary increase in

revenue,at leastuntil thebeginningof the1990s,wasthehigh inflation

triggered by the 1973 oil crisis which, through its interaction with the

progressivityofIRPEF,gaverisetoahugefiscaldrag.Thisledtoasudden

increase inaverageandmarginaltaxrates leviedonthe incomeofthose

unabletoavoidtheapplicationofthetax.Theresultwasanexacerbation

ofthedifference intaxtreatmentbetweenthose,ontheonehand,who

were fully caught, and those,on theother,who had been safeguarded

andprotected fromthe fullandeffectiveapplicationoftheprogressivity

ofthetaxsincethe introductionofthereform,orwhohadsucceeded in

shelteringbehind legal formsofavoidance (exploitingandwidening thegapsandloopholes inthetaxsystem),orwhohadbeendriventoorhad

hidden themselveswithin themazeof taxevasion,helped alongby the

smallscaleoftheiractivities,thedifficultyoftracingtheirtransactionsand

the lackofskillsonthepartoftaxauthoritiesneededtomanageamass

taxationsystem.

Heretoo,afurtherbriefconclusionmaybedrawn,namely:thatataxthat

istheoreticallygoodmayonlyremainsoinpracticeifitdoesnotapplyto

apooloftaxpayersthatistoowideandtoodifferentiated;ifitallowsfor

theadoptionoftechnicalassessmentandcollectionmethodsthatare,asmuch as possible, automatic, uniform and effective; and if it is able to


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adapttoprofoundandunforeseenchangesinexternalcircumstancesthat

substantiallyalteritsdevelopmentandthedistributionofitstaxbase.

8.TaxreformsinachangingscenarioOne of the causes for the radically different effects than those

anticipated oftheoriginalreformplan,orwhatwasleftofitinthelaws

that were actually enacted, was in fact the gap between the socio

economicconditionsusedasa referencepoint for theunderlyingmodel

adoptedduring the formulation stageof the reformand theprofoundly

changedcircumstancesinwhichthereformcametobeapplied.

Inthisregard,oneneedonlyrecallthatduringthegestationperiodofthe

taxreformpackage,theItalianeconomywascharacterisedby:integration

within a relatively stable framework of international economic and

financialrelations(which,amongotherthings,providedforcontrolsover

capital movements); a rather high and not overly variableGDP growth

rate; a relatively low rate of inflation; a still modest level of public

expenditurewhichwaswellbelowthatprevailinginothermajorEuropean

countries; a current account surplus of the public budget close to the

averageforindustrialisednations;andatrendtowardsgrowthinthesize

andorganisationalcapacityofbusinesses.

However,aroundthemid1970swhenthetaxreformpackagecame into

force, the Italian economy was facing radically altered and, to some

extent, opposite conditions to those that had previously prevailed. The

international economic and financial situation was very troubled and

uncertain,anddefactocapitalmobilitypressuresweregrowing,heraldingthefullscaleliberalisationthatwouldbeundertakeninthesecondhalfof

the 1980s; the rateofGDP growthwas slowing and had becomemore

uneven; the rateof inflation exploded and stayed veryhighbecauseof

pressures from increases in rawmaterial prices and the costof labour;

growthinpublicspendingaccelerateduntilitexceeded,inGDPterms,theaverage for European countries; thebudgetdeficit grew rapidlydespite

strong growth in tax revenue; and the trend towards industrial

concentration was curbed while certain large companies had run into

difficulties.

Itisunlikelythatthesametheoreticaltaxmodelcouldbeequallyvalidin

situations so profoundly different and in the face of such a different

configuration of the significant constraints referred to in paragraph 1

above.Thereweremajorchanges incertainconstraints thatwouldhave

impactedontheapplicability inpracticeofany incometaxmodel.Theseincluded: the degree of monetary freedom (which was affected by


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15

internationaleconomicand financial integration)andnationalautonomy

in taxing income from capital; the increase inwellorganised companies

that could act as large tax collectors on behalf of the State (despite

seeking toavoidpaymentof taxes theyowed);and,moregenerally, the

varietyofproductiveororganisational structuresadoptedbybusinessesofdifferentsizeswhichrequireddifferentiatedassessmentmethods,each

ofwhichinvolvedtheirownproblems.

9.ConventionalcriteriainthemeasureofincomeTheinfluenceoftheseandothervariableconstraintsshowsthatthemain

cause of the problems encountered in the implementation of IRPEF in

Italy,andCPPITgenerally, lies insomerespectswiththeveryconceptof

incomeadopted.Ihavealreadyalludedtomybeliefthattheproblemsof

current comprehensiveprogressivepersonal income taxesdo not solely

stem from themultiplicityofadjustmentsmade tototal income through

various formsofdeductionsandallowances,but resultparticularly from

underlyingdifficulties indefining,measuringandassessing the individual

typesof income thatmakeup total income.Thesedifficultieshavebeen

exacerbatedbychangesineconomicandfinancialstructuresandrelations

thathaveincreasinglymadethedefinition,measurementandassessment

of the various types of income for tax purposes more reliant on

establishedconventions(suchasrecognisedaccountingstandards).

Thedifficultiesofdefinitionandmeasurement increaseaccording to the

levelofcomplexityoftheeconomicandfinancialstructure.Calculatingnet

productdoesnotpresentanyparticularproblemsinthatitisobtainedby

comparing uniform and constant magnitudes over time that are

measurableinphysicalterms,suchas,forinstance,thequantityofwheat

input with the quantity of wheat output. However, as is wellknown,

mattersbecomecomplicatedwith theadoptionofproductionprocesses

that, for the production of individual goods, use intermediate inputscomprisingotherproducedgoods indifferentproportions,necessitating

the resort to valuation criteria inorder to arrive at a calculationof net

income.

Different situations have become even more differentiated in cases

involving durable capital assets and unforeseeable technological

innovations, which have necessitated the use of increasingly more

conventionalandadhoccriteriatomeasureincomeornetprofit.Eventhese criteria, despite their being continuously changed and updated,

have proved increasingly inadequate as the level of commensurabilitybetweeninputandoutputintermsofconstantanduniformphysicalunits


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16

hasfallen,duetoproduct innovation,theexpansionofservice industries

(with thedevelopmentofpersonaland financialservicesandsoon)and

thekeyrolenowplayedbytheproductionandexchangeofinformationas

significant indicators of the expectations and behaviour of the various

partiesinvolved.Insuchsituations,whichreflect thecurrentconditionsofacontinuously

evolving economy, the definition andmeasurement of various types of

incomeareinevitablybasedonconventionalcriteria,which,asmuchasit

may be sought to base them on objective and neutral factors, involve

unavoidable subjective considerations. The result is differentiated tax

treatmentsfordifferenttypesof income,dependingontheconventional

calculationcriteriaadopted in individualcases, trends incertainexternal

conditions (such as the rate of inflation, or technological and financial

innovation), taxpayers and tax officials incentives and individual

behaviouralresponses.

Inadditiontothesegeneraldifficulties,whichapplytoallmodernincome

tax systems, in Italy therehavealsobeenproblems stemming from the

laudablebut illusorydecisiontoadoptanallinclusiveconceptoftaxable

incomebasedon an analyticaldeterminationofeffective income20. The

decisionwas praiseworthy because itwas aimed at restoring neutrality

andsimplicitytothetaxsystem,whichshouldhaveledtoanexamination

and review of the basis for the many tax concessions that had

accumulatedovertimeandweredifferentiatedaccordingtocategoriesof

taxpayers, typesof incomeand theapplicable formsof taxwithholding.

Yetitwasalsoanillusorychoicebecausetheproblemsofmodernincome

taxesarisenotonlyonceadjustmentshavebeenmade to total income,

but also, and, above all, stem from the difficulties of defining and

measuring at source the income components that make up total

income. These difficulties impact to varying degrees on the different

categoriesof income,dependingon theextent towhich it ispossible to

detect gross receipts and on the varying levels of complexity of themutablelinkbetweengrossreceiptsandnetincome.

Theargumentthatallincomeisequalforthepurposesofincometaxand

should thereforebe treated in thesamemannermay, from thepointof

viewofsimplicityandneutrality,seemattractive.However,itignoresthe

factthatmostofsuchincomedoesnotexistinapurestate.Rather,the

incomeisderivedandadjusted,accordingtoconventionalruleswhich

leave ample margin for discretionary assessment on the part of tax

authorities and encourage opportunistic behaviour on the part of

taxpayers.


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10.ConclusionThe Italianexperience in the fieldof income taxationdemonstrates the

importanceoftheissuesassociatedwiththedefinition,measurementand

assessmentoftaxbasesinadditiontothoserelatingtotheapplicationofanoptimaltaxrateschedule.Furtheranalysisisrequiredoftheextentto

whichandthewaysinwhichtheseissuesarelinkedtoanddependonthe

actual countryspecific configuration anddevelopmentof the previously

mentioned constraints, namely: the prevailing economic and social

structure; the degree of international integration; institutional setups;

administrativeorganisationandtheattitudesandbehavioursoftaxpayers.

In the case of Italy, the general difficulties involved in administering

modern income taxeshavebeenexacerbatedbecause, from theoutset,

structuralconstraintshavebeenignoredthatarelinkedtothedistinctive

characteristics of Italys business environment, which, more so than in

other countries, is composed predominantly of small businesses, self

employedworkersandahigh levelof fragmentation,heterogeneityand

variabilityintheproductivesystem21.

Similarly,fromtheoutsettherehaveinevitablybeenhighlydifferentiated

tax treatmentsaccording to theclassificationofvarious typesof income

(cases in point include forms of income from capital or the catchall

categoryofotherincome22),thecriteriausedtodeterminetherelevant

tax base (for instance, income from land and buildings, or business

income),andtheassessmentmethodsandrulesused23.Inrelationtothe

latter, various simplifiedor special tax regimeshavebeen introduced in

order to deal with certain characteristics of the Italian business

environment.Thesemeasureshaveincluded:theintroductionofflatrate

schemes for determining turnover; the use of presumptive turnover

coefficients and, without regard to the latter, presumptive income

coefficients;variousversionsof thesocalledredditometro (an indirect

incomecalculator tool);and, finally, thenow longrunning, tortuousandasyetunfinishedsagaofthesocalledstudidisettore (BusinessSectorStudies for the estimation of turnover, costs and income of firms in

specificindustries).

These developments merit further detailed examination in order to

highlight, on one hand, the reasons for and the consequences of the

resort to different (direct and indirect) assessment methods for

determiningthetaxbaseduringtheauditstage,andontheotherhand,to

identifytheminimumnecessaryconditionsregardingthequalityofdata,

the formulation of the analytical model and estimate methods, whichwouldenablea correctandeffectiveuseof statistical indicators for the


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selection of audit targets, thereby preventing forms of econometric

avoidance24.

The different methods and options used for assessing similar types of

income (includingwithin the categories of labour income, income from

capitaland business income)confirm that theproblemsassociatedwithpersonalincometaxesdonotonlystemfromtheimportantaspectsmost

frequentlyanalysedwhich relate to the largelyarbitrary choiceof tax

unit (individual or family) and adjustments made to total income

(deductions)orgrosstax (allowances)butarealso,aboveall, linkedto

thedifficultiesindefining,measuringandassessingtheindividualtypesof

incomethatmakeuptotalincome.

Inparticular,forbusinessincometax,thedifferentiationsintaxbasesare

notonlytheresultofthemoreorlessstrictreferencemadebytaxlawsto

different accounting standards depending on the type of taxpayer to

whomtheyapply (oneneedonly lookatthedifferentiationproducedby

theintroductionoftheIASsforcertaintypesofcompanies)andtheresort

to alarming practices involving taxbase shifting between different

jurisdictionsbymultinationalcompanies.Rather,theyalsostemfromthe

application,particularlywithregardstosmallbusinesses25,ofpresumptive

indicatorsforthepurposesofdefining,measuringandassessingtaxbases

ortobreakthetaxbasesdownintoconstituentcomponents(forinstance,

labour incomeand income fromcapital) thataresubject todifferenttax

treatments.

Thesevarious factors, inaddition to thosepreviouslymentioned, should

be taken into account and analysed carefully when tax changes or tax

reforms (hopefully of an increasingly more farreaching nature) are

proposedaimedatimprovingtheefficiencyandequityofthetaxsystem,

which depend not just on the taxrate schedule adopted but also on

differences intaxtreatmentsresulting fromthedefinition,measurement

and assessment of tax bases. Research dedicated to further examining

theseaspectscouldcontributetoabetterunderstandingoftherationale,causesandeffectsofmanydifferentiatedtaxtreatments,thushelpingto

bridge the gap between tax theory and tax practice in very important

fields forourdiscipline, such as the relationshipsbetween taxation and

economic growth or the various forms of tax competition and tax

harmonisation.


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19

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SteveS.(1984),Conclusioni, inE.GerellieR.Valiani(acuradi).Lacrisi

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1 Theideasofeconomistsandpoliticalphilosophers,bothwhentheyarerightand

when theyarewrong,aremorepowerful than iscommonlyunderstood. Indeed the

worldisruledbylittleelse.Practicalmen,whobelievethemselvestobequiteexempt

from any intellectual influences, are usually the slaves of some defunct economist.Madmen inauthority,whohearvoicesintheair,aredistillingtheirfrenzyfromsome

academic scribblerofa fewyearsback. (Keynes1936,383).Obviously,Keyneswas

not referring to the statements of some of the Finance Ministers of recent years,

thoughhisremarksneverthelessseemveryapt.2 With rare exceptions, the Italians have not been greatly interested in fiscal

reforms .. No reforming spirit has guided the Italians. This has made their

arguments seem sterile anddevoidofnormative content. (Buchanan1960,34 and

72).3Foraclearanalysisoftheseissues,withparticularreferencetothemostwidelyused

conceptofincomefortaxpurposes(namely,incomeasearnings)andcertainaspects

of the Italiansystem,seeLongobardi (2009).Anattempt to link theevolutionof the

Italiantaxsystemaswellastaxreformsintroducedinotherindustrialisednationswith

developments in the fieldofoptimal income taxation theorycanbe found inArtoni,

MichelettoandZanardi(2007).4Lindahl1933,399.Lindahlexaminesfourconceptsofincome:thethreerecalledhere

aswellasincomeasinterest.Itshouldbenotedthatinrelationtoincomeasearnings

astheidealbasicreferencemodelofmanymodernpersonalincometaxationsystems

(including those in the US and Italy), he observes that this concept..hardly

providesanidealsolutionoftheproblemofhowtoarriveataconceptofincomethat

willbeboth tenable theoretically andpracticallyuseful at the same time. (Lindahl

1933,405)


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5 Hicks 1981, 73. Naturally, Hicks adds that although the meanings of income for

theoreticaland taxationpurposesaredifferent, theyareneverthelessconnected.He

alsorecallsthatfromtheinceptionofEnglishincometax,itwasafirmlyheldprinciple

thatincomesofdifferentsortshadtobereachedindifferentways.

6Thisisadebatewhichattimeshasbeenquiteheated,asinthecrowdedcontroversyoverthesocalleddoubletaxationofsavingsor,for instance,thecriticisms levelled

(by themostwellknown supporter of the definition of income as earnings) at the

proposals put forward by Irving Fisher (one of the most noted proponents of the

definition of income as consumption) in his paper Income in Theory and Income

TaxationinPractice.(Simons1938,225sqq.)7 This hasbeen true for a long time at the level of individualnational States (with

reference to thedefinitionof taxable incomeunder theold Italiansystem,cf.Berliri

1949),butithasbecomeincreasinglyimportantevenatthesupranationallevel:see,in

thisregard,theroleplayedinrecentyearsbytheEuropeanCourtofJustice.8

In commenting on the American reforms of 1986 that had substantially andsurprisingly reduced tax ratesandbroadened the taxbase, therebygreatly reducing

thenumberofDTTs,Buchananrecallsthathehadpredicted,onthebasisofatypical

publicchoicemodel,thatAmericanCongresswouldsoonreverttoincreasingtaxrates

on thebroadened taxbase andwould then reintroducemanyDTTs (that is, that it

would[start]resellingtherents).Indeed,thisispreciselywhathappened.(Buchanan

andMusgrave2000,8687)9WithrespecttotheproblemsofmanagingaCPPITextendedtoapplytohighnumber

of taxpayers, cf. Pedone 1984. In relation to the factors that in recent years have

exacerbated these problems, making the application of tax laws even more

differentiatedandarbitrary,cf.AaronandSlemrod2004.10Steve1984,285.

11Theperceptionofataxmaymilitateagainsttheadoptionofataxthatisoptimal

fromastrictlyeconomicpointofview.Thisis,forinstance,thecasewithrespecttotax

onlandrentintheRicardomodel,inwhichthetaxationofrentdoesnotinfluencethe

maximumequilibrium rateofgrowthor theotherequilibriumvaluesof the system,

becausescarceresourceshavethepropertiesofnonbasicproducts;moreover,among

the institutional factors influencing the rate of accumulation and growth in the R

model,areduction in theamountofagivenpretaxrentplaysnorole,because it is

assumedthatallrentsarespent inunproductiveconsumption.So,onewouldexpect

that, since the taxationof rentdoesnotaffect theequilibriumvaluesof the systemanddoesnot influence theprocessofactualeconomicgrowth, it shouldhavebeen

stronglyrecommendedbyRicardo.Butthisisnotthecase(Pedone,1969,80).Oneof

thepossible reasons thatmightexplainRicardosposition is thata taxon land rent

couldbeperceived as a violationof the natural rightofownership and lead to a

widespreadacceptanceofthepossibilityofalsoimpingingonothernaturalrights.12Goode1976,17.

13Theposition in favourofahigh levelofprogressivity,despiteanawarenessof its

disincentiveeffects(tobereducedtoaminimum),isclearlysetoutinSimons1950.14Cosciani1984,40,whogoesontosay:Thedeviationfromeffectiveincomeofone

ormore components thatmake up total income,whether attributable to the legal

definition of income or to exemptions or total or partial evasion, does notmerely

commensuratelyreducethetaxburden it is intendedtoalleviate,butalsotranslates


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into tax relief forother income that is subject tonormal taxation rules inother

words,intoDTTs.15Pechman1990,9.

16ViscoinDeVincentiandPaladini2008,XI.

17FuandRosini1985,9.18Clearly, it isonlywithmuchcaution thatconclusionsmaybedrawn from thisand

the other quantitative ratios mentioned, both because of the shaky theoretical

foundations that support thepresumedeffectsofdifferent tax levelsand schedules

and because of the composition and measurement of the numerator and

denominator. Inrelationtothenumerator, for instance,theresort (variedaswellas

variableovertime)toformsoftaxexpendituresasanalternativetoequivalenttax

concessions insupportoffamiliesandbusinesses,shouldbetaken intoaccount. In

thecasesexaminedinthistext,theorderofmagnitudeseemssuchastothrowcertain

peculiarcharacteristicsofrecentexperiencesinItalyintosharprelief.Cf.Pedone2006

foramoreextensivediscussion.19ItispreciselybecauseIamconvincedthatitisnotpossibletoexpectfromanyone

tax, not even personal income tax, more than it can deliver, and because I am

convincedthatalltaxeshavemajorshortcomings,thatIbelieveitisnecessarytohave

a system which incorporates different tax bases and different criteria for the

distributionoftaxliability.(Steve1984,285)20LongobardiandPedone1994,495.

21Thiswasacknowledgedbyoneof theprincipalarchitectsof the Italian taxreform

package(Visentini1993),whoconsidereditpositive,onthewhole,exceptinrelation

to the important issueof taxationof the incomeof smallbusinessesand freelance

professionals,who,however,quantitativelymakeupavery significantproportionoftheItalianbusinesslandscape.22Foradetailedanalysisofthedevelopmentofthehighlydifferentiatedandvariable

tax treatment of capital and investment income, according to the nature and

characteristics of the relevant investment vehicle, the issuer and the recipient, cf.

RicottiandSanelli2006.23 Inrelationtowhich,whatmatters istheiractualuniformapplication, includingthe

case of simple tax bases such as income fromwork. For instance, the structure of

employmentcanhaveaneffectontheuniformapplicationofthetaxeven inrespect

ofsimilartypesofincomefromwork,inthatanaccurateassessmentofincomefrom

work ismore likelyforemployeesoffirmsthathaveawellformalisedorganisationalstructure, a requisite found more frequently in large firms than small ones.

Consequently, given theexistenceofemployment structuredifferences, an income

taxationmodelthatfunctionswithtolerableerrormarginsintheUnitedKingdommay

onthecontrarybecompletelyinappropriateasitisriddledwithloopholesinItaly.

(Fu1985,39)24Thereportofthecommitteeappointedtoexaminelegalandbusinessissuesarising

in the field of Business Sector Studies highlighted a massive and documented

manipulation of significant information for the calculation of income conformity

thresholds(thesocalledsogliedicongruit,usedinItalytodeterminetheconformityofdeclared turnoverwith theminimumpresumed turnover for the specific typeof

business activity conducted). The committee also noted that the approach used to

define and determine the associated indicators and parameters could introduce


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majordisparitiesbetweenbusinesses,oftentothedisadvantageofsmalltaxpayersor

thosedeemedtobeso(Rey2008,7).25A recentbroadoverviewof theproblemsassociatedwithdefiningandmeasuring

taxable income in the case of ownermanaged businesses and of tax treatments

differentiatedaccording to thevarious legal forms thatbusinessesmay take canbefoundinCrawfordandFreeman2008.

Pubblicato in proprioDipartimento di Economia Pubblica

Facolt di EconomiaUniversit degli Studi di Roma La Sapienza

Via del Castro Laurenziano 9 00161Roma

ISSN 1974-2940


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Working Paper del Dipartimento di Economia PubblicaUniversit degli studi di Roma La Sapienza

Via del Castro Laurenziano 9 00161Roma

COMITATO SCIENTIFICO

Eleonora CavallaroGiuseppe Croce

Debora Di GioacchinoMaurizio Franzini

Luisa GiuriatoDomenico Mario Nuti

Antonio PedoneEnrico Saltari

Annamaria Simonazzi

I Working Paper vengono pubblicati per favorire la tempestiva divulgazione, informa provvisoria o definitiva, dei risultati delle ricerche sulla teoria e la politica

economica. La pubblicazione dei lavori soggetta allapprovazione del ComitatoScientifico, sentito il parere di un referee.


27/27

I Working Paper del Dipartimento di Economia Pubblica ottemperano agli obblighi previstidallart. 1 del D.L .: 31.8.45 n. 660 e dal Decreto del Presidente della Repubblica 3 maggio 2006n.252, art.37.

Antonio PEdone WP119

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