principles of a good tax system
Adam Smith's canons of taxation describe the principles of a good, fair and efficient tax system
Efficient taxes raise revenue without negative distortions such as reducing work-incentives for individuals and investment incentives for companies.
Indirect taxes can create a deadweight loss of economic welfare. For example, taxes on restaurant meals and personal computers cause a deadweight loss of consumer surplus
Lump-sum taxes tend to be most efficient. Once they have been paid, there is no disincentive to earn extra income or achieve a higher profit since the tax liability does not grow. (The marginal rate of tax is zero)
Unfortunately lump-sum taxes do not discriminate between rich and poor tax-payers. A £500 lump -sum tax would hit a low-income earner much more heavily than a high-income household.
An efficient tax system raises the revenue needed at the lowest possible cost to the tax-payer.
Equity and the Benefit Principle
Taxes should be fair and based on people's ability to pay.
The benefits principle argues that people should pay taxes according to the benefit (utility) they derive from consuming government goods and services.
There is often a trade-off to be made between equity and efficiency. For example a cut in the marginal rate of tax for higher income people might be justified on the grounds that it encourages greater work effort and higher labour productivity. However lower taxes for the rich make the tax system less progressive and might increase the scale of inequality between rich and poor. Governments must be careful not to set higher tax rates too high so that disincentive effects become large.
Equally the tax system can also create disincentives at the lower end of the income scale.
Tax-payers should understand how the system works difficult to evade. Tax rates should be relatively stable from year to year and should not be subject to sudden fluctuations. This allows people to undertake their own financial planning knowing the basic tax liabilities they will face in the coming year.
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