1

Chapter 1

Fundamental Issues of Taxation

Topics

1.1 Why to study tax

1.2 What is tax

1.3 History

1.4 Types of tax

1.5 Economics of taxation

1.6 Views on Taxation

1.7 Fundamental factors of tax law

1.1 Why to study tax

I have five houses, I don’t need work, because I can live on rents.

I have only one apartment, and I have to work.

I have no place, and I sell vegetables in the market.

1.1 Why to study tax

That’s OK, I don’t need to pay. After the housing price drops, I will buy another one.

Very good! I don’t need to pay. After the housing price drops, I will buy one house.

Housing property tax is coming…

Fine…The tax rate is 1%? Right. The rent will increase 5% from the next month…

1.1 Why to study tax

Oh, my god! The price of vegetables increased everywhere. I have to eat less…

I’m really depressed, but I will take actions, the price of vegetables will increase by 5%...

Rents increased everywhere…

1.1 Why to study tax

• Ending of the story…

7

1.1 Why to study tax• Taxation long has been a primary link

between the people and their government. In the United States today, more people file tax return than vote in the presidential elections, and the politics of taxation influences electoral debate of every level of office seeking. A French minister once called taxation the art of plucking the goose with the least amount of squawking .Lately we have heard lots of squawking.

• Taxes affect the terms of almost every economic decisions that an individual or a company makes.

Individual decions affected • The rewards obtains from saving• Working hard• Taking a second job• Investing in education or training, treasury bond or

stock, house or stock• How much it costs to contribute to charity• Put children in day care• Smoking• Drinking wine ,beer or orange juice• Going to cinema or night club

Company decisions affected• Whether and how much to invest in a new

technology • Whether to locate a factory in U.S. or in China• Whether to run a enterprise in the form of

corporate, partnership or sole proprietorship• Whether to take a depreciation policy of

straight-line method(units-of-production method ) or accelerate depreciation method(double-declining method,sum-of-years digits method)

• How to finance your business

1.2 What is tax

• 1.2.1 Concept

• 1.2.2 Purposes and effects

1.2.1 Concept• Tax is a compulsory levy made by public authority for

which nothing received directly in return( A Dictionary of Taxation (1998) by Simon James

• Tax is a charge assessed on an individual or on property for the purpose of supporting the functioning of the government.

• Tax is what we pay for the civilized society.• Tax is the process by a government transfers

resource (almost always money) from the private to the public sector.

• Tax is the price for the public good.

1.2.2 Purpose and effect

• 1.2.2.1 The Four "R"s

• 1.2.2.2 Proportional, progressive, and regressive

• 1.2.2.3 Direct and indirect

• 1.2.2.4 Tax incidence

1.2.2.1 The Four “R”s• Taxation has four main purposes or effects: • Revenue (The main purpose)• Redistribution• Repricing• Representation

1.2.2.1 The Four “R”s• Revenue, taxes raise money to spend on

armies, roads, schools and hospitals, and on more indirect government functions like market regulation or legal systems.

• Redistribution, taxes transfer wealth from the richer sections of society to poorer sections.

• Repricing, taxes are levied to address externalities; for example, tobacco is taxed to discourage smoking, and a carbon tax discourages use of carbon-based fuels.

• .

Representation, "no taxation without representation" , rulers tax citizens, and citizens demand accountability from their rulers as the other part of this bargain

1.2.2.2 Proportional, progressive, and regressive

• An important feature of tax systems is the percentage of the tax burden as it relates to income or consumption.

• The terms progressive, regressive, and proportional describe a distribution effect, which can be applied to any type of tax system (income or consumption).

1.2.2.2 Proportional, progressive, and regressive

• A progressive tax is a tax imposed so that the effective tax rate increases as the amount to which the rate is applied increases.

• A regressive tax, where the effective tax rate decreases as the amount to which the rate is applied increases.

• A proportional tax, where the effective tax rate is fixed, while the amount to which the rate is applied increases.

1.2.2.3 Direct and indirect• An economic definition, by Atkinson, states that

"...direct taxes may be adjusted to the individual characteristics of the taxpayer, whereas indirect taxes are levied on transactions irrespective of the circumstances of buyer or seller.“

• Payroll, income, and wealth taxes are called direct taxes because they indirectly tax individual resources.

• Consumption taxes are called indirect taxes because they tax the use of these resources rather than the resources themselves.

1.2.2.4 Tax incidence

• Distributional Implications-- Who really bears the burden of taxation – Tax incidence

• (a) Statutory Incidence is the legal liability for a tax; is determined by who pays the tax to the government; ignores the fact that markets react to taxation.

• (b) Economic Incidence is the actual burden of the tax; is the difference between the individual’s available resources before and after the tax has been imposed.

1.2.2.4 Tax incidence• An Example:• Suppose the price of a bottle of wine is $10. The

government imposes a tax of $1 per bottle, to be collected in the follwing ways: Every time a bottle is purchased, the tax collector (who is lurking about the store) takes a dollar out of the wine seller’s hand before the money is put into the cash register.

• Suppose that a few weeks after its imposition, the tax induces a price rise to $11 per bottle, $10.30 per bottle, or the price stays at $10, what is the tax burden for consumers and producers?

1.2.2.4 Tax incidence

• (a) For consumers the tax burden is:

consumer tax burden = (posttax price – pretax price) + tax payments by consumers

• (b) For producers the tax burden is:

producer tax burden = (pretax price – posttax price) + tax payments by producers

1.2.2.4 Tax incidence• Three Rules of Tax Incidence:• Rule 1: The statutory burden of a tax does not

describe who really bears the tax;• Rule 2: The side of the market on which the tax is

imposed is irrelevant to the distribution of the tax burdens;

• Rule 3: Parties with inelastic supply or demand bear taxes; Parties with elastic supply or demand avoid them

• Reminder: Tax incidence is about prices,not quantities.

Rule 3 (Perfectly Inelastic Demand)

1.2.2.4 Tax incidence

P

Q

S2S1

D Inelastic Factors Bear Taxes. A tax on producers of an inelastically demanded good is fully reflected in increased prices, so consumers bear the full tax.

Rule 3 (Perfectly Elastic Demand)

1.2.2.4 Tax incidence

P

Q

D

S2S1

Elastic Factors Aviod Taxes. A tax on producers of a perfectly elastically demanded good cannot be passed along to consumers through an increase in prices, so that producers bear the full burden of the tax.

1.3 History

• 1.3.1 A brief history of taxation

• 1.3.2 Taxation levels

1.3.1 A brief history of taxation

• 1.3.1.1 A brief history of taxation around the world

• 1.3.1.2 A brief history of taxation in China

• 1.3.1.3 A brief history of taxation in U.S.

1.3.1.1 A brief history of taxation around the world

• The first known system of taxation was in Ancient Egypt around 3000 BC - 2800 BC in the first dynasty of the Old Kingdom.Records from the time document that the pharaoh would conduct a biennial tour of the kingdom, collecting tax revenues from the people. Other records are granary receipts on limestone flakes and papyrus.

• Early taxation is also described in the Bible. In Genesis (chapter 47, verse 24 - the New International Version), it states "But when the crop comes in, give a fifth of it to Pharaoh. The other four-fifths you may keep as seed for the fields and as food for yourselves and your households and your children". Joseph was telling the people of Egypt how to divide their crop, providing a portion to the Pharaoh. A share (20%) of the crop was the tax.

1.3.1.1 A brief history of taxation around the world

• In India, Islamic rulers imposed jizya (a poll tax on non-Muslims) starting in the 11th century. It was abolished by Akbar.

• Numerous records of government tax collection in Europe since at least the 17th century are still available today

• Xia-gong( 贡 )

• Shang-zhu( 助 )

• Zhou-che( 彻 )

• Warring States period(403-221BC),tax system was gradually improved by means of enactment of statutory provision(Chushuimu-初税亩 )

1.3.1.2 A brief history of taxation in China

• Qin （ 316BC ） :land tax（地税）， poll tax（人头税）

• Han Dynasty （ 206BC ） ,a system of monopolized sale of salt,iron and wine was practiced

• Northern Wei Dynasty(386-534)-Sui Dynasty （ 581-618 ） -early Tang Dynasty （ 618-907 ） ,Juntianzhi(均田制 )

• The middle phase of Tang Dynasty,zu yong diao(租庸调 )

• The final phase of Tang Dynasty-Song Dynasty(960-1279)-Yuan Dynasty(1279-1368)-Ming Dynasty(1368-1644), two-tax system（两税法）

1.3.1.2 A brief history of taxation in China

• Zhangjuzheng(张居正 )of Ming Dynasty ， single tax in silver ， 1581 （一条鞭法）

• Qing Dynasty ， Yongzheng ， tandingrumu（摊丁入亩） ;After Opium War(1840-1842),The Qing government lost its power in the legislation and collection of customs duties,and the salt tax was also usurped by the western powers.

• Kuomingtang government’s tax system

1.3.1.2 A brief history of taxation in China

The nationwide unification of tax policies in 1950

• Nationwide Implementation of Tax Policy ： good tax, industrial and commercial tax, salt tax, customs duty, salary income tax, depository income tax, special consumption act tax, stamp duty, legacy tax, trading tax, livestock slaughtering tax, housing tax, land tax, tax for use of vehicle and vessel licenses,etc.

• 1953 amendment of the tax law

• The 1958 reform of the industrial and commercial tax system and the nationwide consolidation of the agricultural tax law

• 1973 reform of the industrial and commercial tax system

All-round reform of the tax system after 1979

• 1980,Individual Income Tax Law of the P.R.C.• 1981,Income Tax Law OF the P.R.C for Enterprises

with Foreign Investmetn and Foreign Enterprises • After 1983,Law of the P.R.C. on enterprises(state-

owned, collective owned,private-owned ) income tax• 1984,turnover tax law(product tax,vat,business tax)• So far,A compound tax system was established in

China

The tax reform of 1994• Value-added-tax• Business tax• Consumption tax • tariff tax • Enterprise income tax • Foreing-funded enterprised and foreign enterprises income tax• Individual income tax• Land valued-added tax• Urban construction and maintenance tax• Property tax• Resource tax• Stamp tax• Vehicle and Vessel Use tax• Deed tax

• Early taxes• A century of tariffs• The civil war income tax• The twentieth century: expansion and

entrenchment of income and wages taxes• The beginning of the twenty-first century:tax

cuts and deficits

1.3.1.3 A brief history of taxation in U.S.

Early taxes• 1791,distilled spirit tax and carriage tax---Alexander Hamilton

regarded it as “more as a measure of social discipline than as a source of revenue”

--Distilled spirit tax caused a “Whiskey rebellion” of 1794 --The carriage tax produced the first Supreme Court case to

consider the constitutional validity of an exercise of the taxing power,and the tax was upheld in Hylton v. United States,3 U.S(3 Dall.) 171(1796),on the ground that it was not a “direct tax” required to be aprrotioned among th states by population under Article 1, section2, clause3 of the Constitution.

---The first year’s receitpts from internal taxes netted the federal government a grand total of ＄ 208,942.81

• 1792,snuff tax ,sugar tax ,acution sales tax, bonds tax,…

• 1798,a direct dax was enacted on real property tax (houses and land) and slaves(a tax of fifty cents on all slaves between the ages of twelve and fifty)

• 1802,Jefferson repealled all the tax except salt tax and tariff

Early taxes

A century of tariffs

• 1817-the Civil War, the federal government didn’t again require revenues from internal taxes until the Civil War. During the interim, the government financed all of its activities from tariffs and sales of public land. Trade tariffs remained the most significant single source of federal revenues until 1894.

• Tariffs were increased to an average rate of nearly 50 percent in 1890

The civil Income tax• 1861,real property• 1862,7,1,first income tax signed by President

Lincoln(it applied to income in excess of ＄ 600,and taxed amount up to ＄ 10,000 at 3 percent rate with income exceeding that amount taxed at 5 percent)

• The 1862 ACT also imposed taxes on inheritance in excess of ＄ 1,000 with rates graduate from 0.75% depending on how close a relative the beneficiary was to the decedent.

• The provisions of the Wilson-Gorman Tariff Act of 1894 required that, for a five-year period, any "gains, profits and incomes" in excess of $4,000 would be taxed at 2%.

Pollock v Farmers’ Loan ＆ trust Co.

• Pollock v Farmers’ Loan ＆ trust Co.,158 U.S. 601(1895)

• Pollock v. Farmers' Loan & Trust Company, 157 U.S. 429 (1895), aff'd on reh'g, 158 U.S. 601 (1895), with a ruling of 5–4, was a landmark case in which the Supreme Court of the United States ruled that the unapportioned income taxes on interest, dividends and rents imposed by the Income Tax Act of 1894 were, in effect, direct taxes, and were unconstitutional because they violated the provision that direct taxes be apportioned. The decision was nullified in 1913 by Amendment XVI to the US Constitution,which permit Congress to tax income “from whatever source derived”

The twentieth Century:Expansion and Entrenchmnent of Income and Wage Tax

• Corporation income tax was introduced in 1909,imposing a tax of 1 percent on corporate net in excess of ＄ 5,000

• The enactment of social security in 1935• Extension of the Income Tax to Most

Americans: From the Second World War on, the levy of income tax was converted from a limited scope(400,000 individuals) into a tax on the messes; income tax rates reached their peak of 94 percent during the Second World War.

The tax reform of 1986

• A pattern of “low tax rate and broad tax base ” reform

• The highest marginal tax rate lowered from 94% to 28%(31%)

The beginning of the Twenty-first Century:Tax cuts and Deficit

• The Presidency of George W.Bush took Reagan’s approach a step further by enacting in 2001 a large phase-in cuts in both the income tax and estate tax. This was followed in 2003 by reductions in the taxation of individuals and capital gains and an accelerated implementation of the tax enacted in 2001.The 2004 act extended various tax cut passed in 2001that were scheduled to expire before 2010.By 2004,federal taxes as a percentage of gross domestic production reached a forty-five year low of 16.1 percent.

1.3.2 Taxation levels

France 1600~10 1650~59 1700~10 2003

Taxation Levels

(millions)24.30 126.86 117.99 ——

Percentage of GDP 15%~20% 54.5%

1.3.2 Taxation levels

2003 Denmark France Euro area UK

Percentage of GDP 56.1% 54.5% 49.0% 42.6%

2003 US Ireland OECDs

Percentage of GDP 35.7% 35.2 40.7%

U.S. NATIONAL DEBT CLOCK

美国债务钟发出的警示 U.S. NATIONAL DEBT CLOCK

The Outstanding Public Debt as of 31 Dec. 2009 at 09:33:14 AM GMT is:

个人和企业债务 25 万亿 ;

金融债 16.7 万亿美国总债务

超过 52 万亿

2010.2.4 债务 12.35次日国会将债务限额由 12.37 提升至 14.27

As of 07 Oct 2010 at 12:54:07 AM GMT is:

财政赤字警戒线

财政赤字 <GDP 3%

1.4 Types of Tax

• 1.4.1 Five most common types of taxes;• 1.4.2 Taxation Around the World

1.4.1 Five most common types of taxes

• (a) Taxes on Earnings• (b) Taxes on Individual Income• (c) Taxes on Corporate Income• (d) Taxes on Wealth• (e) Taxes on Consumption

1.4.1 Five most common types of taxes

• (a) Taxes on Earnings• Payroll Tax -- A tax levied on the earnings of

workers.• Payroll taxes are the primary means of financing

social insurance programs (Social Security, unemployment insurance, Medicare, and so on).

• (b) Taxes on Individual Income• Individual Income Tax – A tax paid by individuals

on income accrued during the year.• The tax is distinguished from the payroll tax by• 1) a broader set of income sources, such as interest

earnings (the taxation of capital gains).• 2) applying in many cases to the entire income of a

family, not just to the income of one individual worker.

• 3)progressive tax rate

1.4.1 Five most common types of taxes

• (c) Taxes on Corporate Income• Corporate Income Tax – A tax levied on the

earnings of corporation.• The purpose of this tax is to tax earnings of owners

of capital that might otherwise escape taxation by the individual-based income tax system.

1.4.1 Five most common types of taxes

• (d) Taxes on Wealth• Wealth Taxes – Taxes paid not on income as it is

accrued but on the value of the assets held by a person or family.

• Included in the category are state and local property taxes, which are based on the value of land and any structures built on the land, and estate taxes, which are based on inheritances left behind when one dies.

1.4.1 Five most common types of taxes

• (e) Taxes on Consumption• Consumption Tax – Tax is paid on individual or

household consumption of goods and sometimes services as well (most common around the world).

• Consumption taxes are often levied in the form of Sales Taxes, taxes that are paid by consumers to vendors at the point of sale.

• When applied to only certain goods, such as cigarettes or gasoline, the sales tax is called an excise tax.

1.4.1 Five most common types of taxes

1.4.2 Taxation Around the World

• Figures will show the distribution of tax revenues across these different types of taxes in China, United States and in other nations.

• (a) Tax revenues by type of Tax in China• (2008, % of total tax revenue)

1.4.2 Taxation Around the World

Tax Category (2008 in China) Tax Revenue (10000 yuan) Proportion

Value-Added Tax 252,664,104 0.436668

Consumption Tax 28,460,860 0.049188

Business Tax 76,283,956 0.131838

Enterprise Income Tax 121,951,634 0.210764

Individual Income Tax 37,223,126 0.064331

Resources Tax 3,016,361 0.005213

Fixed Assets Investment Orientation Regulation Tax

12,762 0.000022

Urban Maintenance and Construction Tax 13,442,000 0.023231

House Property Tax 6,802,766 0.011757

Stamp Tax 13,201,542 0.022816

Urban and Town Land Use Tax 8,168,892 0.014118

Land Appreciation Tax 5,374,418 0.009288

Vehicle and Vessel Tax 1,441,863 0.002492

Motor Vehicles Purchase Tax 9,898,720 0.017108

Leaf Tobacco Tax 672,395 0.001162

Others 2,564 0.000004

Total 578,617,963 \

1.4.2 Taxation Around the World

• (b) Tax revenues by type of Tax in U.S.• (2001, % of total tax revenue)

1.4.2 Taxation Around the World

1.4.2 Taxation Around the World

(c) Tax revenues by type of Tax in Norway and Mexico

(2001, % of total tax revenue)

1.4.2 Taxation Around the World

1.5 Economics of Taxation• In economic terms, taxation transfers wealth from

households or businesses to the government of a nation. The side-effects of taxation and theories about how best to tax are an important subject in microeconomics. Taxation is almost never a simple transfer of wealth. Economic theories of taxation approach the question of how to minimize the loss of economic welfare through taxation and also discuss how a nation can perform redistribution of wealth in the most efficient manner.

1.5 Economics of taxation• 1.5.1 Fairness; 1.5.2 Efficiency

• 1.5.1.1 Concept of Fairness• 1.5.1.2 Measuring the Fairness

1.5.1 Fairness

• Margaret Thatcher was ousted as leader of the Conservative Party in 1990 . What is the immediate cause?

• A tax reform proposal – replace the system of property taxes (based on real estate value) with a poll tax.

• Poll tax, a flat charge levied equally on all individuals, regardless of whether they were rich, poor, or somewhere in between. It is efficient but it is not fair.

Tax fairness is an important concern to citizens worldwide

• 1.5.1.1 Concept of Fairness• Vertical Equity and Horizontal Equity• (a) Vertical Equity, the principle that groups with

more resources (higher income, higher wealth, higher profits) should pay higher taxes than do lower-resource groups.

• (b) Horizontal Equity, the principle that individuals who are similar but who make different economic or lifestyle choices should be treated in the same way by the tax sysytem.

1.5.1 Fairness

• 1.5.1.2 Measuring the Fairness• Assumptions ;

• (a) Income taxes are borne fully by the households that pay them;

• (b) Payroll taxes are borne fully by workers, regardless of whether these taxes are paid by the workers or by the firm;

• (c) Excise taxes are fully shifted forward to prices and so are borne by individuals in proportion to their consumption of the taxed item (consistent with both theory and empirical evidence);

• (d) Corporate taxes are fully shifted to the owners of capital and so are borne in proportion to each individual’s capital income (not as progressive as it indicates).

1.5.1 Fairness

• 1.5.1.2 Measuring the Fairness

• Means – Proportional, progressive, or regressive

• How progressive (v1 or v2) –algebraically, let T0 and T1 be the true (as opposed to statutory) tax liabilities at income levels I0 and I1, respectively (I1 is greater than I0).

01

1 01

1 0

TT

I Iv

I I

1 0 1 0

20 0

( ) ( )T T I Iv

T I

1.5.1 Fairness

01

1 01

1 0

TT

I Iv

I I

1 0 1 0

20 0

( ) ( )T T I Iv

T I

• 1.5.2.1 Deadweight loss• 1.5.2.2 Transparency and simplicity• 1.5.2.3 Cost of compliance

1.5.2 Efficiency

1.5.2.1 Deadweight loss

• two cases • Arnold Harberger, One of the pioneers of the general

equilibrium tax incidence model ,once wrote of his experience in Indonesia ,where cars are taxed more heavily than motorcycles. This tax differences provided a great incentive to make motorcycles more carlike.

• An Englishman visiting Cyprus in the early 1980’s,asked a tour guide why so many of the house seemed to have steel reinforcement bars jutting out of from their top floors.The guide informed him that Cyprus had a building tax that applied only to finished structures.Owners of those houses could thus claim that they were still in the process of finishing the roof.

• Implication: markets do not take tax lying down.—if there is some action that markets participants can undertake to mininize the burden of taxation ,they will do so. As long as there are substitutes for the consupmtion of any taxed good,some consumers will shift to those substitutes to avoid the tax, and as long as there are alternatives to the production of taxed goods ,some producers will shift into producing those alternatives.

• Deadweight loss is the amount of social efficiency sacrificed by society when trades are impeded by the presence of taxation.

• TIPS:• The inefficiency of any tax is determined by the

extent to which consumers and producers change their behavior to avoid the tax; deadweight loss is caused by individuals and firms making inefficient consumption and production choices in order to avoid taxation.

1.5.2.1 Deadweight loss

Determinants of Deadweight Loss

• Deadweight loss is a function of the elasticities of supply and demand and the size of the tax .For convenience ,economists often focus on the simplified cases where supply is perfectly elastic but demand is not. In this case ,the formula for DWL is

2(1 / 2) ( / )dDWL Q P

• Two important lesson from the equotion:• First, DWL rises with the elasticity of demand

and supply: the more opportunities market participants have to consume or produce substitutes (the more elastic is demand or supply), the greater the inefficiency they will create by substituting.

• Second, the DWL rises with the square of the tax rate(), so that the distortion from any given amount of tax is larger if the existing tax base is large.

• Implications for the Design of Efficient Tax Policy:• Progressive tax system can be less efficient: it apply

not only to taxation of goods but to taxation of income as well. A implication of this rule about DWL is that there can be large efficiency costs in moving from proportional (equal average tax rates on all) to progressive( higher average tax on the rich) tax system. In general , it is more efficient to tax all individuals at an equal rate (a proportional tax), than to exclude some individuals from taxation and tax other individuals at a higher tax rate to make up for the lost revenues(a progressive tax).

1.5.2.1 Deadweight loss

The efficiency lost by taxing a subset of individuals more highly is larger than the efficiency gained by excluding some individuals from taxation.

• Government should “smooth” tax rates over time—a tax of 40% in one period and 20% in the next causes more DWL than a tax of 21% for 20 years.

• The complicated tax codes of developed economies offer perverse economic incentives. The more details of tax policy there are, the more opportunities for legal tax avoidance and illegal tax evasion; these not only result in lost revenue, but involve additional deadweight costs.

• To address these issues, economists often suggest simple and transparent tax structures which avoid providing loopholes. Sales tax, for instance, can be replaced with a value added tax which disregards intermediate transactions.

1.5.2.2 Transparency and simplicity

• In a single year,the IRS processes over 174 million returns,including 134 million individual returns. It audits or examines about 1.3 million tax returns and additionally sends 3.5 million computer-generated notices to taxpayers who are suspected of having reported incorrect tax liabilities. IRS estimated that about 16 percent of what should be paid in personal and corporate income tax ,amounting to ＄ 345 billion, is not paid and that ＄ 290 billion of this will be never collected.

• Although governments must spend money on tax collection activities, some of the costs, particularly for keeping records and filling out forms, are borne by businesses and by private individuals. These are collectively called costs of compliance.

• More complex tax systems tend to have higher costs of compliance. This fact can be used as the basis for practical or moral arguments in favor of tax simplification

1.5.2.3 Costs of compliance

• Literally billions of hours are spent every year in the U.S. on fundamentally unproductive tax-related activities such as recordkeeping ,wading through instruction ,hunting for deductions and credits, and arranging personal and business financial affairs to avoid unnecesary tax payments and to take advantage of tax preference.

• In total ,individual taxpayers spend as much as 3 billion hours of their own time on tax matters,or about 27 hours per taxpayer on average.

1.6 Views on Taxation

• 1.6.1 Ethical basis of taxation;• 1.6.2 Optimal taxation theory;• 1.6.3 Views opposed to taxation

1.6.1 Ethical basis of taxation

• According to most political philosophies, taxes are justified as they fund activities that are necessary and beneficial to society.

• Additionally, progressive taxation can be used to reduce economic inequality in a society.

• Oliver Wendell Holmes, Jr. stated "Taxes are the price of civilization".

• 1.6.2.1 Optimal Commodty Taxation• 1.6.2.2 Optimal Income Taxes

1.6.2 Optimal taxation theory

1.6.2.1 Optimal commodity taxation

• The theory of optimal commodity taxation began with early twentieth-century economist Frank Ramsey ,who considered the problem of a government with a given budget requirement and the ability to set different tax rates for different commodities (food ,clothing, tobacco, and so on ).Ramsey formulated the problem of optimal taxation by asking the question: How can we raise a given amount of revenue with least amount of distortion ? In other words, how should a government set its tax rates across a set of commodities to minimize the DWL of the tax system while meeting its budgetary requirement?

• (a) Ramsey Rule• The government should set taxes across

commodities so that the ratio of marginal DWL to marginal revenue raised is equal across the commodities.

• Ramsey rule: set commodity taxes such that

Where MDWL is the marginal deadweihgt loss from increasing the tax on good i ,MR is the marginal revenue raised from that tax increase, and is the value of additional government revenues.

1.6.2.1 Optimal commodity taxation

i

i

MDWL

MR

• This rule states that the DWL per dollar of tax revenue associated with an additional dollar of taxes on commodities i should be equal for all commodities.

• It tells the government to set the marginal cost of taxation equal to its marginal benefit .

• (b) Inverse Elasticity Rule:• It indicates that elastic good should be taxed less and inelastic

goods taxed more.• We must balance two factors,• 1) The elasticity rule: When elasticity of demand for a good is

high, it should be taxed at a low rate; when elasticity is low, the tax rate should be high. The DWL from any tax rises with the elasticity of demand, so efficiency is enhanced by taxing inelastic goods more than elastic goods

• 2) The broad base rule: It is better to tax a wide variety of goods at a moderate rate than to tax very few goods at a high rate. Because the DWL from a tax rises with the square of the tax rate, the government should spread taxes across a large number of commodities and not tax any one commodity at a very high rate.

1.6.2.1 Optimal commodity taxation

• To balance these two recommendations, the government should tax inelastically demanded goods at higher rate, but should not look to collect all its taxes from these goods unless the price elasticity of demand is perfectly inelastic. If a government cared only about the elasticity rule, it would find the most elastic good and raise all revenues from taxing that good. The broad base rule ,however, tempers the tendency. Thus, while the government should tax inelastic goods more highly, it should tax other goods as well.

• (c) Equity Implications:• This inverse elasticity formulation of Ramsey model

highlights the fairly nasty equity implication of the Remsey approach. Imagine that the government has only two goods it could tax : cereal and caviar…

• As the elasticity of demand for necessity is much lower than that for the other goods, so the inverse elasticity rule would suggest that the government tax necessity much more highly than the others.

• This outcome, while efficient, might violate a government’s sense of tax fairness across income groups (vertical equity).

1.6.2.1 Optimal commodity taxation

• An optimal commodity tax framework can address equity concerns by taking into account not only the elasticity of each commodity but also the income distribution of its consumers. Goods that are disproportionately consumed by higher-income consumers could have a tax rate above that implied by the inverse elasticity rule, and goods that are disproportionately consumed by lower-income consumers could have a tax rate below that implied by the inverse elasticity rule. How much of this “reweighting” of optimal taxes across commodities should be done is a function of the extent to which governments want to trade off efficiency for equity. As the government moves away from the Ramsey efficiency rule by bringing in equity issues, the tax system becomes less efficient but more equitable.

• The goal of optimal income tax analysis is to identify a schedule of tax rates across income groups that maximizes social welfare, while recognizing that raising tax rate that has conflicting( and , if taxes are high enough, negative )effects on revenue.

1.6.2.2 Optimal income taxes

• The optimal income tax system meets the following condition:

• Set income tax rate across groups such that

• Where MU is the marginal utility of individual , MR is the marginal government revenues, and is the value of additional government revenues.

• The optimal income tax system is one in which the marginal utility per dollar of revenue raised is equalized across individuals.

/i iMU MR

• (a) The Laffer Curve:• As tax rate rise from 0 to t*, tax revenues rise; but

when tax rates rise above t* toward 100%, tax revenues fall.

Tax revenues

Tax rate

“Right side”

“Wrong side”

100%t*%0

1.6.2.2 Optimal income taxes

• (b) Balancing• We must balance two factors• 1) Vertical Equity: Social welfare is maximized when

those who have a high level of consumption, and thus a low marginal utility, are taxed more heavily, vice versa.

• 2) Behavioral Responses: As taxes rise on any one group, they respond by earning less income. This means that an additional increase in taxes will raise less revenue, because the base of taxation is smaller.

1.6.2.2 Optimal income taxes

1.6.3 Views opposed to Taxation

• Because payment of tax is compulsory and enforced by the legal system, some political philosophies view taxation as theft (or as a violation of property rights), or tyranny, accusing the government of levying taxes via force and coercive means.

• Walter E. Williams, professor of economics at George Mason University, stated "Government income redistribution programs produce the same result as theft. In fact, that's what a thief does; he redistributes income. The difference between government and thievery is mostly a matter of legality. ”

1.7 Fundamental factors of tax law

• Taxpayer, a person or a legal person who pays taxes to the government legally.

• Tax base, the object in tax law, it explains what we levy on, and it is the essential difference of different tax categories.

• Tax rate, the ratio between tax liability and tax base, it measures the tax burden.

• The timing of tax liability arising, the assessable period for tax payment, tax payment place…