In many countries, taxation forms a single leading source of government revenue for funding national budgets. Other non-tax revenue sources such as foreign grants play a comparatively less significant role in sustaining public budgets than the role played by taxation. In general, governments use taxation to meet two main objectives viz. to generate sufficient revenue for public spending thereby limiting domestic borrowing and ensuring equity and increasing incentive effects in all sectors of the economy. Over time, many countries have implemented tax reforms in a bid to generate additional tax revenues to sustain public spending while maintaining a favorable tax burden. However, more often, the reforms result in a high tax burden that affects the prospects of raising more revenue. In addition, mistrust and lack of public confidence in tax systems are some of the outstanding tax reform challenges in most countries leading to cases of tax evasion or non-compliance.
Even though the tax reforms in most countries herald prospects of improved tax revenue collection, tax codes, characterized by high tax rates concerning commerce, and complex tax systems that are difficult to administer, are selective and unresponsive to economic growth; therefore, they are the key challenges facing tax reforms. In designing a tax system, governments should aim to attract investment and reduce compliance costs.
Tax Policy and Social Equity
To develop a tax system that improves social equity in many countries, three critical factors ought to be considered. These factors include; the level of compliance, the amount of revenue generated, and the tax structure suitable for the economy. Unfortunately, in the majority of countries, the levels of non-compliance are high, the tax system is unfair, and the tax burden is low.
Social equity implies the equality of all citizens in a country’s laws. In this context, a tax policy provides one of the fiscal tools for the enforcement of the principles of social equity. While other government fiscal policies may have impacts on social equity, budgetary decisions based on public expenditure and the level of revenue are indispensable in ensuring fair income distribution and equity in society. Therefore, the concept of social equity should be central to any government’s fiscal policy. In economics, tax equity as reflected in a government’s tax revenues and expenditures is closely related to public spending.
The principle of tax equity focuses on the payment capacity of individuals i.e. their ability to handle a country’s tax burden. Therefore, the principle of tax equity is, without a doubt, central to any tax reform. According to Massage, Kam, and Heady, a country’s tax system should be equitable in the distribution of income and tax burden in the society taking into account the individual economic circumstances (Massere, Kam, & Heady 2004, p. 97). In other words, all members of society must shoulder the tax burden equally to ensure justice about the payment of taxes. This can be achieved in two ways; that is, horizontal and vertical equity principles.
In horizontal equity, individuals in equal economic circumstances are subjected to equal tax treatment, whereas in vertical equity, the unequal tax treatment is implemented for individuals in differing economic circumstances. As Bird (2003) puts it, an appropriate tax system should incorporate the four principles of taxation viz. “equality, redistribution, proportionality, and generality” (p. 387). However, the ‘equal’ and ‘unequal’ treatment accorded to individuals depending on their economic ability often makes it difficult to implement the four principles. Nevertheless, redistribution should be core to any government’s tax policy to achieve economic equity.
In consolidating the income taxes, the concepts of progressive taxation and proportional taxation should be considered. Proportional taxation comes first, and it involves taxation proportional to an individual’s income. Progressive taxation, on the other hand, involves implementing proportionally higher taxes for individuals with a higher capacity to pay. Concerning progressive taxation, a government should determine an appropriate level of taxation to be incorporated in a country’s tax system, in line with its redistribution policies and goals.
The principle of generality implies fairness in the distribution of the tax burden among citizens. All citizens fund public spending through various taxes and fiscal tools. Others such as property and income taxes are most notable while others such as indirect taxes are not visible (Bird 2003, p.392). To ensure compliance, governments should raise awareness about the taxes and tax burden. Additionally, citizens should be made aware of any tax exemptions. Issues such as increased tax-exempt minimums may create a false impression that certain people enjoy tax exemption while others do not. Consequently, social divisions or tax evasion may arise among the population. However, in truth, all citizens pay taxes on their incomes. Thus, raising awareness as per the principle of generality results in a more cohesive and tax-compliant society.
Another principle of an effective tax system is sufficiency. To ensure economic equity, the tax system should be able to generate sufficient revenue. In any economy, government resources fund public services and utilities (Buti, Sestito, & Wijkander 2001, p. 112). Thus, the tax system must be able to allocate these resources more appropriately. However, in this context, the issue of sufficient revenue to finance public goods and services arises. Governments should consider the expenditures to be financed, whether the expenditures are justifiable and whether appropriate monitoring and evaluation mechanisms that ensure efficiency in public spending are in place during the implementation of tax reforms. In addition, the tax system implemented should be able to raise sufficient resources to fund quality public services (Buti, Sestito, & Wijkander 2001, p. 114). In most societies, particularly high-income societies, citizens demand quality services. Thus, any tax system should be able to generate enough revenue to enhance sustained public spending.
Taxation and Direct Investment
Taxation significantly affects economic growth as it influences direct investments on multiple levels. Taxation influences the choice of investment destination i.e. where to invest as well as the investment size. It also influences management decisions that regard expenditure on employment, purchase of industrial equipment, and plant establishment. According to Schneider and Enste, a country with a relatively high tax burden, despite other favorable factors such as low operating costs, political stability, and increased access to markets discourages investments in the various sectors of its economy (2000, p.89)
Thus, while taxation policies are essential to any economy, policymakers should consider the capacity of the tax system to attract investments. In particular, the tax system’s ability to encourage compliance as well as promote transparency and economic stability can promote investment. A poorly designed tax system that lacks transparency is unpredictable, or is exceedingly complex may discourage capital investment. This arises because a lack of transparency increases uncertainty over the project costs as well as the overall profitability of the investment.
In addition, tax systems that entirely delegate the assignment of taxation to the discretion of Treasury officials may encourage corruption, which discourages investments (Schneider, & Enste 2000, p.93). In this context, a government should, therefore, ensure that its tax system entails a tax burden that is easily determined and is favorable to business enterprises. Additionally, about investment, the tax system should be able to minimize the project risks, lower the tax administration costs, as well as promote tax compliance.
Taxation also has an indirect influence on investments. Taxation determines the size of revenue, which forms a significant source of government expenditure for the development of a country’s physical infrastructure as well as human capital. The tax system should, therefore, aim at creating a favorable investment environment, which is a key consideration for investors (Massere, Kam, & Heady 2004, p. 102). In addition, a tax policy that encourages both foreign and domestic investment and raises sufficient revenue that enables a country to develop its infrastructure is often a challenge to policymakers. To achieve these objectives, the tax system should be consistent and transparent. Moreover, the government must ensure effective implementation of the tax policy to promote confidence and create an attractive environment for investment.
In tax policy development, information on various aspects of taxation is essential. It requires, at the basic level, estimates of how changes in tax rates would affect the size of revenue as well as the different taxes that contribute to the total tax. In addition, the tax policy should be politically feasible. In other words, the policymakers should identify the population segments likely to shoulder a higher tax burden and those who are likely to benefit; i.e. pay smaller taxes under a particular tax system.
Other key considerations include how the tax system would influence risk-taking and entrepreneurship, labor mobility, and interest rates, which are essential in promoting economic development. Policymakers must assess how compliance with the tax system contributes to the overall tax burden. A high tax burden discourages entrepreneurship and investment in the economy. Moreover, governments should consider whether the tax system threatens the tax base by allocating profits to low tax sectors of the economy. A government should also implement a neutral tax treatment with low compliance costs, which lowers the tax burden, especially for small businesses.
Simplified taxation provisions that incorporate neutral tax treatment contribute to improved efficiency and encourage compliance with the tax policies. Additionally, they encourage entrepreneurship and the growth of business investments in the economy. Nevertheless, policymakers should carefully design the simplification provisions to curb tax evasion or noncompliance to avoid questions regarding the integrity of the tax system as well as horizontal equity concerns. In this regard, most countries have simplified tax regimes especially for small and medium enterprises (SMEs) to reduce compliance costs.
A paragon tax system should yield adequate revenue and possess a favorable tax burden. Additionally, the tax system should create a favorable environment to attract investment. From a taxation perspective, issues of compliance costs, tax burden, revenue sufficiency, and public spending significantly influence the social equity of citizens. In particular, aspects of a taxation system such as tax structure, tax avoidance, and revenue generated have an impact on equity. Thus, in designing tax systems, governments should consider compliance costs as well as the tax burden to promote equity and encourage investment.
Bird, M., 2003. A New Look at Local Business Taxes. Tax Notes International, 30(7), pp. 387─394.
Buti, M., Sestito, P., Wijkander, H., 2001. Taxation, Welfare, and the Crisis of Unemployment in Europe. London: Routledge.
Massere, K., Kam, F., & Heady, C., 2004. Tax Policy: Theory and Practice in OECD Countries. London: Routledge.
Schneider, F., & Enste, D., 2000. Shadow economies: size, causes, and Consequences. Journal of Economic Literature, 38(1), pp. 89−94.