An examination of the incentive effects of taxes
Part – A:
The conventional wisdom is that tax incentives are bad in theory and practice as well. Taxation is argued to induce adverse impact, as these actions tend to distort investment decisions. Easson & Zolt (2001) argue that tax incentives often generate ineffectiveness, inefficient and vulnerable to abuse and corruption. Yet tax incentives are common fiscal policy decisions around the globe taken in the form of tax credits, favorable tax treatment, accelerated depreciation (Klemm & Parys, 2009). Major tax incentive schemes have been attached with protection and development of domestic industries and attract foreign direct investments (James & Nobes, 2004).
The place to start discussion on tax incentives it to evaluate the role of governments in promoting growth and development. Tax policy is one of the most important tools for governments to raise revenues and fund expenditures. The economic efficiency suggests that tax policy should lead to just and equitable redistribution of income in a society. Easson & Zolt (2001) argue that all forms of taxation are distortive and exhibit types of market failures. For example, income taxes distort returns on capital and labor and taxation on consumption to reduce spending. Zee, Stotsky & Ley (2002) have defined tax incentives in terms of their effectiveness as exclusions, exemptions and deductions that tend to reduce the effective tax burden for a specific project or investment. Market failures have led to the economic theory of usefulness of incentive effects of taxes to promote efficiency and investments – i.e. transfer of technology, increased employment, attracting foreign direct investments. While governments may achieve these objectives but tax incentives do not compensate for structural problems and deficiencies in the design of the tax system or sustainable economic growth. Klemm & Parys, (2009) argue that economists remain skeptical of the tan incentives to provide with benefits in the long run. Tax incentives are provided a specific group by imposing higher tax burden on the other groups. Thus, if the gap at both ends is significantly wide than the incentive effects of taxation may actually lead to negative impact. This is explained in the Laffer curve (James & Nobes, 2004).
If the tax rate on specific groups (i.e. high earners) is too high to compensate for tax credits to others (i.e. less privileged) then it may result in disincentive for higher taxpayers to work hard or make profits. Large tax imbalances may also result economic distortions stemming from top earners to avoid or evade taxes. The overall effect of the tax incentives to a small group in the long run may actually lead to lower revenues generated and unsustainable tax incentive policies. A study by Adam Smith Institute (2011) is sample evidence where capital gain tax rate increase from 30% to 40% by United Kingdom in 1988 resulted in tax revenues to decline by more than half. In recent times, an incremental raise in the income tax from 40% to 50% on the top earners in the UK and providing tax incentives to the lower income groups by raising the minimum taxable income levels has widened the gap. Angela Beech (analyst) has indicated that increased gap to induce a negative impact on investments in the UK market (BBC, 2010).
Thus, tax incentives may seem great in idea and in theory but not in the practice at least in the long run. In the real world, tax incentives pertinent to domestic markets growth, economic prosperity and job creation have not exhibited goods records. Tax incentives may be useful in the short run to boost competitiveness and promote investments in specific sectors but the long run policy is identified to be expensive and inefficient (Thorndike, 2011).
Part – B:
The tax avoidance and tax evasion are two different issues from the legal point of view but the economic view is less explicit on the difference, suggesting both types of distortions to generate revenue losses from taxable sources (James & Nobes, 2004). Tax avoidance and evasion are both crucial problems that distort the efficiency, effectiveness and stability of government fiscal polices and redistribution of wealth to maximize social and economic welfare (Cowell, 1985). The willingness and responsive of the taxpayers is argued to depend on design and features of the tax system. According to (Smith, 1776) the basic principles for a designing a good tax system are equity, certainty, convenience and efficiency.
A tax system is equitable if it promotes fairness. Fairness in a taxation system is regarded as a framework in which tax imposed on all individuals is to be just and levied according to taxpayers’ ability and willingness to pay (James & Nobes, 1999). This is ensured when the tax design is able to reflect attributes of simplicity and equitable burden. Simplicity of the tax system is argued by Kopczuk (2006) to be an important requirement for a good design. This is because a complex tax provisions provide arbitragers with significant opportunities to avoid or evade taxation. Kopczuk (2006) argues that complexity allows arbitragers to attempt ways to shield their income from being taxed. Kopczuk (2006) also argues that tax distortions as a result of complexity may also result from the possibility of taxpayers making inadvertent mistakes in estimating their tax liabilities. Consequently, both the strands indicate that complexity also increases the overall cost of taxation as a result of expenditures for tracking and taking legal actions. Lymer & Oats (2009) suggests that simplicity in the tax remove loopholes for arbitragers to exploit tax avoidance and evasion. Nevertheless, simplicity aspect of tax design is also exposed to few limitations that distort fairness of the tax levied upon taxpayers. A fair burden of tax levied refers to a tax system in which different groups (i.e. high and low income earners) pay disproportionate levels of tax according to taxpayers, income, ability and willingness (i.e. utility to avoid taxation is lower than to go to prison). An equitable tax system is a trade-off between simplicity and fairness achievable by a design that uses a balanced approach.
The second principle of certainty in the tax system is also important factor in minimizing tax avoidance distortions. This principle of a good tax system is defined as taxpayers having complete information on their tax liabilities i.e. methods of payments, payment deadline, amount to be paid. The third principle focuses on convenience of the taxpayers to give away taxable portion of their income. This is broader objective than fairness in designing a tax system emphasizing on distribution of tax burden on taxpayers with identical earning levels. (Smith, 1776) suggested that distribution of tax burden should involve factors such as children in policy making on distribution system of tax levied.
Lack of these fundamentals in a tax system is argued to induce distortions and damage the confidence and willingness of the taxpayers in the economy. Many economists have recommended various tax structures as good designs for promoting efficiency and effectiveness of tax collection. Mintz (2003) has argued levy of consumption tax as a entire tax base to be most efficient at collection of tax and minimizing distortions. On the other hand, Graetz (2005) has suggested an income tax levied on only top 5 percent and consumption tax levied on each household to be a good design for a tax system. Graetz (2005) argues that exclusion of low-income groups from income tax base to reduce administrative costs. James Graham (analyst) has a viewpoint that recent changes in the tax system of UK such as increase in the capital gains tax from 18 percent to 28 percent to be inequitable for top earners and thus may induce economic distortions (Teather, 2010). Lloyd George (analyst) arguing that too much burden on a selected group may motivate distortive activities of tax evasion has also rejected the design proposed by Graetz (2005). The equitable factor implies that each household should contribute in the taxation no matter how poor they are since the reallocation of funds benefits the entire population.
Lymer & Oats (2009) explains that taxes should be used as a tool to promote good behaviors in the society. In order to achieve this redistribution of the revenues from tax base must promote fiscal policies of benefit to all, economic prosperity for all groups and confidence in the system. Taxpayers will be willing to pay taxes if they consider the system to be equitable and reallocation of funds also improves their welfare.
I do believe that however equitable and convenient a tax system may be, markets failures are inevitable as Stiglitz (2010) argues that markets as efficient as the participants want it to be. Thus, presence of information asymmetry between tax administration and taxpayer suggests problems of tax evasion. Besfamille & Parlatore Siritto (2009) argue that for designing an optimal tax-enforcement system that addresses tax avoidance and evasion issues, the system should meet three conditions i) poor individuals earn an income and therefore should be taxed to not burden any specific group too much, ii) the government should implement fiscal polices that are coherent with maximization of utilitarian criterion i.e. taxpayers have willingness to pay, and iii) government should administrate tax audits to identify any market failures and detect tax evaders and impose penalties and punishment. Such costs tend to be too high for the taxpayers to evade taxation.
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