Tax Policy Objectives
Taxation imposes a burden on both the economy and society. Many people have thought about what the main objectives of tax policy should be, and while these desirable objectives are easily ascertained, few nations follow most of them because of the influence of special interests, especially the wealthy, in determining public policy. Nonetheless, the following tax policy objectives have been deemed desirable by their prevalence in the literature, by the prevalence of their citations, and because they are commonsensible.
Adam Smith, in his Wealth of Nations, listed what he called the canons of taxation, which is still valid today:
- Ability to Pay. The taxpayer should pay an amount based on his ability to pay, which depends on his income.
- Certainty. A desirable tax structure should be predictable and consistent, meaning that the taxpayer should know when, where, and how the tax will be levied, so that individuals and businesses, and other organizations can readily ascertain the tax consequences of any endeavor or transaction. Of course, this is a desirable characteristic of any law.
- Good Timing. Taxes should be assessed when the taxpayer is most able to pay. This principle was particularly apt in Adam Smith's day, when most people were farmers and made most of their money at particular times of the year. Nowadays, with most economies being highly diversified, good timing has much less relevance. However, modern economies did adopt Adam Smith's maxim that taxes are easier to pay if they are paid in portions periodically, which most nations impose on its taxpayers by requiring employers to withhold taxes from the pay of employees and by requiring self-employed individuals to make estimated tax payments.
- Economy. Collection costs by the government and compliance costs by the taxpayer should be minimized. Minimizing collection costs leaves more money for the government to carry out its functions. Minimizing compliance costs leaves more time and money for the taxpayer.
In 2001, the American Institute of Certified Public Accountants (AICPA) published a monograph titled Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals which listed 6 additional objectives of tax policy. Some of these principles are either restatements of Adam Smith or subsumable under more general principles. The most important additional principles stated is that taxation should not reduce economic efficiency and that the tax system should be structured to minimize noncompliance and to accurately estimate the amount collectible, so that the government will have a better assessment of its revenues. Additionally, taxation should not distort the economy by causing individuals and businesses to engage in activities solely because of the tax.
The United States Tax System
Judging by the above listed canons of taxation, the United States government system of taxation fails miserably. Although the federal income tax is progressive, many wealthy people pay far less in taxes as a percentage of their income than people who make much lower amounts. This results from the fact that the Social Security tax and Medicare tax are applied only to earned income — which, of course, is why they are called employment taxes — not to investment income nor to inherited income, which constitutes much of the income for the wealthy, and because the Social Security tax is only applied to earned income up to a certain limit, which, currently, exceeds $140,000.
Filing taxes is much more convenient today, since taxes are generally collected by the employer from employees, and, certainly, electronic filing and tax software have greatly simplified the filing of taxes. However, for many taxpayers, tax software acts as a black box, because few people can really understand the extremely complex nature of the tax code.
As far as certainty goes, taxpayers can readily calculate the taxes on simple transactions, but income taxes are much harder to predict, since there are so many exclusions and exemptions, and the tax code changes from year to year. Nonetheless, most people have a ballpark figure of their average tax rate based on their past payments.
The tax system has greatly increased in complexity, because Congress is constantly providing loopholes to favored constituents. And nowadays, businesses and other organizations constantly assess how taxes will affect their transactions to determine what will be profitable.
Noncompliance has been rampant in the past, but this will change as electronic systems provide more information about everyone. Indeed, money itself will become entirely electronic, which will allow the tax authorities to ensure that everyone pays the taxes required by law. The Internal Revenue Service (IRS), which is the tax collecting authority of the United States government, always likes to say that people should pay their fair share of taxes, but many people would contend that to pay a fair share requires that the tax law itself be fair.
The greatest negative effect of taxation on economic growth and efficiency is the tax burden imposed on earned income, because it increases the cost of labor to businesses and reduces the price that the providers of labor receive for their work. It has long been a well-established principal in economics that when suppliers get less money for their product, they supply less and when the buyers of that service have to pay higher prices, they demand less. Since labor is a major economic factor of production, this creates or increases an economic output gap, reducing economic output below what it would be without taxes on wages. In economics, this inefficiency is what is known as the deadweight loss of taxation.
Why doesn't Congress reduce taxes on wages and increase taxes on investment and inheritance? After all, greater economic output increases the wealth of the country as a whole, which increases the amount of tax revenue collected. It is because the wealthy have an outsized influence on Congress, and, indeed, most members of Congress are wealthy in their own right, and because, inexplicably, the voters have not demanded otherwise.