To assess the merits of a tax system, it must be considered as its whole. For a tax system to be good, it can’t only have all good taxes and no bad ones. The state is unable to raise sufficient revenue while also pleasing taxpayers. As a result, it is important to understand that a good tax system does not imply a flawless tax system with only good taxes based on the canons of taxation, generating sufficient revenues, and causing no harm to the taxpayer. A good taxation system is one that mostly carries good taxes and meets most tax canons. The following are the characteristics of a good tax system:
- Fiscal Adequacy
One of the most fundamental principles of a good tax system for a developing country is that it should provide the government with sufficient money to enable it to carry out its expanding welfare and development operations. If the tax system fails to generate sufficient revenue, the government will be forced to rely on deficit financing.
Excessive deficit financing will inevitably boost prices, which will be bad for society. To be adequately productive, the tax system must be wide-ranging, with both direct and indirect taxes included. Furthermore, taxes should be progressive, meaning that the revenue generated increases as people’s income rises.
Adequacy means that taxes must offer sufficient income to satisfy the fundamental requirements of society. If there is enough income to cover the demand for public services, if income growth every year is enough to finance the increase in services costs, and if sufficient economic activity of the kind is taxed so that the rates may be considerably lower, then a tax system meets the criteria of adequacy.
The idea of diversity should be followed by a good tax system. This means that the government should not rely on a single or a few taxes to generate significant revenue. If a government seeks to obtain substantial revenues from a single tax or a few taxes, then tax rates must be too high, not only affecting incentives for jobs and savings and investing but also fostering tax fraud.
As a result, the tax system should be a multi-tax system with a wide range of taxes, requiring all those who can pay to the government purse to do so. This necessitates a combination of direct and indirect levies. With the diverse tax system, the principles of fiscal adequacy and equity will also be better satisfied.
- Taxation for Ensuring Economic Stability
Economic stability shall also be guaranteed through a tax system. Economic fluctuations in industrialized countries have been a major problem and taxation can play a significant role in minimizing these variations. To this end, there must be integrated flexibility in the tax system. The tax system must be progressive in response to changes in national incomes in order to have built-in flexibility.
This ensures that the Government automatically increases a growing part of the increase in revenue when national revenues rise. On the other side, as in recession or depression, national income falls and tax revenues gradually decline faster than national income declines.
Built-in flexibility through gradual taxation guarantees that as incomes rise during the boom or inflation period, relatively higher levels of government revenue moderate the growth in purchasing power and collective demand, helping to control prices.
Similarly, tax revenue will fall quicker than income under progressive taxation at a period of depression or recession, so that people’s purchasing power will not fall as rapidly as before tax revenues. This will check economic activity decline. In emerging countries, however, the difficulty is mainly in curbing inflation so that price stability may be achieved. Taxation can play a useful role in managing inflation in developing nations by discouraging or curbing spending, in particular non-essential or nonproductive expenditure.
- Fairness or Equity
Fairness or equity is one of Adam Smith’s characteristics of a good tax system. It means that fairness or equity is a fair share of the taxes that everyone should pay. The majority of such taxes that create beneficial impacts on the generation of national income and wealth and equal distribution must be included in a good tax system. A good tax system plays a very essential role in achieving the socialist aims of public policy.
The weight and burden of taxation should be balanced. The weight refers to the taxpayer’s total sacrifice in terms of purchasing power of actual income relinquished. This burden involves the taxpayer’s relative ability to pay tax.
Horizontal equity and vertical equity are two key notions of Adam Smith’s fairness and equity. Horizontal equity entails taxpayers paying equivalent tax amounts in similar financial circumstances. However, vertical equity is as crucial. Vertical equity means that the better-off taxpayers must pay at least the same share of income as the less well-off taxpayers. Taxes are classified as regressive, proportional, or progressive in order to achieve vertical equity.
(a) Regressive tax: A tax is regressive when low-income tax payers pay a greater proportion of their income in taxes than income tax payers. Almost any essentials tax, such as food purchased at a grocers’ shop, is regressive, as individuals with lower incomes have to spend more on these things.
(b) Proportional tax: If all taxpayers paid equal percentage of tax revenue, a tax is proportional. Taxes don’t really matter. Because there is usually a strong relationship between a household’s income and the value of the property in which they live, property taxes are generally the closest. Corporate income taxes are often proportional since the majority of corporate revenue is subject to a rate.
(c) Progressive tax: Individuals with greater incomes must pay a higher percentage of their income in taxes under a progressive tax. Progressive taxes are based on the idea that persons with higher incomes can afford and should be expected to provide a larger share of public services than those with lower incomes.
Although no tax system is flawless, horizontal equity is crucial because taxpayers must think that they are treated in the same way. It’s also critical to pursue vertical equity so that government doesn’t become a burden for low-income citizens.
Simplicity is also one of Adam Smith’s stated characteristics of a good tax system. Simplicity means a maze of fees, formats, and filing requirements can be avoided by taxpayers. A good tax system will improve taxpayers’ understanding of the system and reduce compliance costs.
- Elasticity of Taxation
Another instrument to reduce economic inequality should be a good tax system for a developing economy. The aim of a successful tax system for a developing economic system is not just to increase the government’s income, but also to ensure that tax burdens are higher for the wealthiest.
The principle of tax elasticity is another characteristic of a good tax system for developing countries. Under the notion of taxation elasticity, the government revenues from taxes should also increase with increased national revenues as a result of economic expansion.
The share of tax revenues as a percentage of national income in emerging countries is low compared to industrialized countries. If the tax system is sufficiently elastic, this tax revenue share will increase when national incomes rise. This implies a sufficiently high rate of progressive direct income, wealth, expenditure, capital gains, etc. If a good part of tax income is used for poverty alleviation activities, this purpose to reduce income inequality will be better served.
The tax system becomes more elastic when higher indirect (axes are imposed on luxury products with a high-income elasticity of demand.
Transparency refers to the ease with which taxpayers and leaders can learn about the tax system and how tax money is spent. We know who is being taxed, how much they are paying, and what is being done with the money in a transparent tax system. We may also see who pays the tax (in general) and who is eligible for tax exemptions, deductions, and credits.
- Administrative Ease
Administrative ease means either taxpayers or tax collectors do not find the system too cumbersome or expensive. The rules are generally known and pretty straightforward; forms are not too complex; the state can tell whether taxes are paid in due course and correctly and that the state can carry out audits fairly and effectively. In proportion to the amount collected, the cost of collecting a tax should be very little.
- Taxation as in Instrument of Economic Growth
Taxation should be a tool for economic growth in a developing economy such as ours. The primary purpose of economic growth is the pace of the formation of capital. If the public sector is given an eminent place in the development plan, the capital formation must take place at a fairly higher rate in the public sector.
This requires government resources to be mobilized to finance public sector capital formation. The Government would therefore be able to mobilize appropriate resources for capital formation or economic expansion in a good taxation scheme for the developing country. This can be accomplished in two ways:
(a) Mobilisation of Economic Surplus:
One of the most fundamental principles for a developing country is to mobilize its economic surplus. The “surplus of national income above essential consumption” is referred to as an economic surplus. It is the responsibility of the taxation system to constrain non-essential or unproductive consumption through a suitable system of progressive direct and indirect taxes, mobilizing economic surplus in the process.
There are some economic sectors and groups of people in an underdeveloped economy where the economic surplus is usually found, and which should thus obtain special consideration from tax authorities in such countries.
(b) Increase in the Intermental Saving Ratio:
A good tax system is not only attempting to mobilize the current economic surplus but is also trying to enhance it with the aim of increasing the quantity of national income substantially much larger for capital formation purposes. In the developing economy, therefore, taxation must not only restrict current unproductive consumption but also control the substantial rises in consumption when economic surplus increases due to an increase in national revenue.
This ensures an increase in the incremental or marginal saving ratio that is a key predictor of ongoing economic growth. In other words, it should not be possible to increase the proportion of income using taxation consumption.
Individual economic surpluses should be mobilized and invested in the public sector to help the economy develop further. This will be ensured by a progressive income tax and indirect taxes on items with a higher income elasticity.
Based on the previous study, we can conclude that taxation is used to achieve a variety of socioeconomic goals in today’s society. It isn’t only a way to raise money for the government’s limited functions. The neutrality principle of taxes, i.e., leaving things as they are, is no longer popular among current economists. Today’s tax system must play a more beneficial role. Its goals include achieving rapid economic growth, reducing income inequality, promoting stability, achieving other socio-economic goals, and others.