Question

Assume you are a fresh graduate from UPSA with Public Finance as one of your specializations. You have been
employed by the Ministry of Finance in your country. The government of your country is in the process of
designing a better tax system in order to maximize revenue for accelerated economic development.
a. Your superior has assigned you the task of assisting in designing the new tax system. Discuss what a good
tax system would require and explain the specific economic challenges that affect taxation in your country.

b. Explain two (2) major reasons why the incidence of taxation should be of paramount importance to the
Government.
c. Discuss four (4) major recommendations you would offer a neigbouring country that is in the process of
introducing VAT in their country.

Answer 1

(a)

A good tax system should meet five basic conditions: -

• Fairness: It means that everybody should pay a fair share of taxes. There are two important concepts of equity: horizontal equity and vertical equity. Horizontal equity means that taxpayers in similar financial condition should pay similar amounts in taxes. Vertical equity is just as important, however. Vertical equity means that taxpayers who are better off should pay at least the same proportion of income in taxes as those who are less well off.
• Simplicity: It means that taxpayers can avoid a maze of taxes, forms and filing requirements. A simpler tax system helps taxpayers better understand the system and reduces the costs of compliance.
• Administrative ease: It means that the tax system is not too complicated or costly for either taxpayers or tax collectors. Rules are well known and fairly simple; forms are not too complicated; the state can tell if taxes are paid on time and correctly, and the state can conduct audits in a fair and efficient manner. The cost of collecting a tax should be very small in relation to the amount collected.
• Transparency: It means that taxpayers and leaders can easily find information about the tax system and how tax money is used. With a transparent tax system, we know who is being taxed, how much they are paying, and what is being done with the money. We also can find out who pays the tax and who benefits from tax exemptions, deductions, and credits.
• Adequacy: It means that taxes must provide enough revenue to meet the basic needs of society. A tax system meets the test of adequacy if it provides enough revenue to meet the demand for public services, if revenue growth each year is enough to fund. A self-balancing accounting structure with revenues, expenditures, assets and liabilities used to track monies flowing. The growth in cost of services, and if there is enough economic activity of the type being taxed so rates can be kept relatively low.

Primarily through the supply side, high marginal tax rates can discourage work, saving, investment, and innovation, while specific tax preferences can affect the allocation of economic resources. But tax cuts can also slow long-run economic growth by increasing deficits. The long-run effects of tax policies thus depend not only on their incentive effects but also their deficit effects.

The Congressional Budget Office and the Joint Committee on Taxation each use multiple models that differ in assumptions about how forward-looking people are, how the United States connects to the global economy, how government borrowing affects private investment, and how businesses and individuals respond to tax changes. Models used in other government agencies, in think tanks, and in academia vary even more. The one area of consensus is that the most pro-growth policies are those that improve incentives to work, save, invest, and innovate without driving up long-run deficits. The Urban-Brookings Tax Policy Center (TPC) has developed its own economic model to analyze the long-run economic effects of tax proposals. In TPC’s model, simple reduced-form equations based on empirical analysis determine the impact of tax policy on labor supply, saving, and investment. TPC used this model to estimate the long-run economic and revenue effects of the Tax Cuts and Jobs Act.

(b)

The amount of the tax cost for businesses matters for investment and growth. Where taxes are high, businesses are more inclined to opt out of the formal sector. A study shows that higher tax rates are associated with fewer formal businesses and lower private investment. A 10-percentage point increase in the effective corporate income tax rate is associated with a reduction in the ratio of investment to GDP of up to 2 percentage points and a decrease in the business entry rate of about 1 percentage point.3 A tax increase equivalent to 1% of GDP reduces output over the next three years by nearly 3%. Keeping tax rates at a reasonable level can encourage the development of the private sector and the formalization of businesses. Modest tax rates are particularly important to small and medium-sizeenterprises, which contribute to economic growth and employment but do not add significantly to tax revenue.

To foster economic growth and development governments need sustainable sources of funding for social programs and public investments. Programs providing health, education, infrastructure and other services are important to achieve the common goal of a prosperous, functional and orderly society. And they require that governments raise revenues. Taxation not only pays for public goods and services; it is also a key ingredient in the social contract between citizens and the economy. How taxes are raised and spent can determine a government’s very legitimacy. Holding governments accountable encourages the effective administration of tax revenues and, more widely, good public financial management.1

All governments need revenue, but the challenge is to carefully choose not only the level of tax rates but also the tax base. Governments also need to design a tax compliance system that will not discourage taxpayers from participating. Recent firm survey data for 147 economies show that companies consider tax rates to be among the top five constraints to their operations and tax administration to be among the top 11. Firms in economies that score better on the doing business ease of paying taxes indicators tend to perceive both tax rates and tax administration as less of an obstacle to business.

(c)

The first is to enact drastic cuts in the entitlement programs. But that is politically unacceptable and will not happen. The second possibility is to raise additional revenues from the existing income and payroll taxes. This can be done by raising the rates, broadening the base or both. But both broadening and higher rates are very unpopular politically, and high income tax rates cause familiar economic distortions and lead to increased evasion and avoidance. At a time where other countries are cutting income tax rates, this seems a very imlausible choice. The third option is to enact a VAT. This is what every other OECD member country has chosen to do under similafr circumstances. The VAT is a proven revenue generator and can combine with spending cuts resolve our budgetary problem. We believe it is thhe only realistic solution.