Why does a country need taxes? Mainly for two reasons:
a) To generate essential resources for the government to provide public goods such as defence, police, highways, etc.; and
b) reduce the opportunity gap between rich and poor. Through social spending, especially on health, education, and social security, money raised through taxes can help ensure that an individual’s future is not entirely dependent on the family’s economic or social status she is born in.
With these as the end goals, how are taxes collected? Mainly through two major forms,
i) Direct taxes paid by individuals/corporations on their incomes, wealth, and capital gains – these taxes generally differ based on their levied individual. Typically, they are progressive in nature, i.e., a person with more income/wealth ends up paying a higher percentage and vice versa.
ii) Indirect taxes such as VAT and GST are driven by consumption, i.e., higher the consumption, higher the tax contribution of an individual. Another important feature of indirect taxes is that they are levied at the same rate for all.
The virtues of direct and indirect taxes If one thinks about the two major objectives of taxes (minimising opportunity gap and provision of public goods), a clear logic emerges on the virtue of the existence of both direct and indirect taxes. Because public goods and services equally benefit all, i.e., they don’t differentiate between the rich and poor, all citizens’ indirect taxes (irrespective of their economic status) make sense.
Similarly, because an individual’s status in life is very much dependent on the family of his/her birth, direct and progressive taxes appear sensible. We live in a world where education and hard work are necessary but certainly not enough to catapult all individuals born in poor income brackets into higher ones.
A recent New York Times article mentions that nearly 67 per cent of students at Harvard University come from the top 20 per cent of American families in terms of income. Only 1.8 per cent of students come from poor backgrounds and end up as rich adults. The story isn’t different for other top universities. Thus, direct taxes targeted at the relatively rich help plug the opportunity gap determined by one’s birth. Optimal tax rates a vital and often controversial subject is tax rates. Any common person would question the basis of deciding a rate of tax. So far, I am yet to come across a decent argument on why tax rates are set at specific values.
What’s the rationale for deciding tax rates on cars or cinema tickets, on high-income individuals or low-income ones?
Certainly, maximising tax revenues can’t be the only goal, as high tax rates can potentially dent economic activity. If taxes are too high, what would be the incentive for an individual to earn more, as the government takes away most of his/her earnings? Similarly, a high indirect tax rate on goods would lower their consumption, hurting the economic activity associated with producing such goods. However, the principle of taxation has been well documented for ages. Just google “Laffer Curve”, and you will see an ‘inverted U’ shaped diagram with tax revenues on Y-axis and tax rates on X-axis. The diagram is quite intuitive and indicates that with an initial increase in tax rates, tax revenues rise, peak at a certain rate, and then start falling. But is it so easy to draw a Laffer Curve for any country? I doubt it.
Interestingly, the same principle was highlighted in the Hindu text of Mahabharata.
In Shanti Parva, Bhishma Pitamah, while lying down on a bed of arrows and answering Yudhishthira’s questions on Rajdharma (or a duty of the government), mentions it through an excellent analogy. “An intelligent king [government] will milk the kingdom [country] like a calf that sucks milk. If the calf is nurtured, it becomes strong and can sustain hardships. A kingdom that has been milked too much is incapable of achieving anything great”.
He further adds, “earlier, kings levied high taxes and low ones. The lord of the earth [government] must act so that there is no deprivation anywhere. He must glance towards the outcome of a task and then determine taxes. It should never be such that there is no incentive for the work and the outcome”.
Despite these principles & theories – both historic and modern, tax rates appear more discretionary than principle/need-based. This ends up giving undue powers to business lobbies or labour unions to render a tax system inefficient.
Imagining an ideal tax system So, what could be an ideal tax system with tax levels that address all the current challenges and is based on moral and economic principles? A system with 3 major components can help. One, direct taxes on income and wealth accumulated by individual and corporations: Since these entities work hard to earn income and are drivers of economic activity, it is cruel & inefficient to tax hard-earned income at high/unjustified rates.
However, a tax rate that generates enough revenues to help the government provide for basic public goods and services such as law & order, roads, national security, among others, would be ideal. In short, Adam Smith’s first maxim of taxation that argues for ‘taxation in proportion to the benefits a taxpayer receives from the state and should be predictable, convenient, and efficient’ needs to be followed in letter and spirit. For corporations, direct taxes can be flat. For individuals, they can be progressive to account for the inherited abilities gained through better education by those born in relatively accomplished households. Two, a reasonable inheritance tax covers all transfers of wealth from one generation to the other for a sizable number of wealthy households: This form bodes well for minimising the opportunity-gap objective. It levels the playing field as kids born in rich families won’t get a huge financial leg-up in the form of inheritances.
The pitfall with this form of tax is that it may provide a disincentive for individuals to save and earn. The primary motivation for many to work hard is to see that their kids don’t face financial problems in their lives. However, as time progresses, such a tax may indeed usher in a cultural change through which the future success of kids will be much less reliant on their parents’ wealth. It will likely make an economy more consumption-centric and reduce overall savings, but there are enough policy instruments to offset such a change. Three, near-zero indirect taxes except on sin goods that degrade social value (such as alcohol and tobacco) and select super-luxury goods: In an economy with a large direct tax-base, there appears no reason to be dependent on indirect taxes. Indirect taxes have been used in developing countries majorly for ease of implementation.
However, they are too paternalistic in their design. They end up shaping consumer choices. Who has given the government the moral authority to decide that consuming bakery items should be more expensive than restaurant food?
However, for practical reasons and a smooth transition, a low single-rate tax on all goods and services is optimal until direct taxes are enough to provide for public goods. A system with these three components essentially means that Direct & Indirect Tax Collections will be earmarked to provide public goods. Inheritance Tax Collections will be earmarked for closing the opportunity gap between rich and poor. Ideally, governments would restrain mixing revenue streams from these two forms of taxes. Further, fixed-term tax rates (very much like fixed-term governments) can add predictability to the tax system and make it transparent. Taxes are termed tyrannical tools mainly for their nature of being unfair. A sound system that ‘is’ and ‘appears’ fair can transform them into a social good force.
(The author is a Young Professional with the Economic Advisory Council to the Prime Minister, New Delhi. The views expressed are strictly personal)