Question

QUESTION 1
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

Point A :

In simple words we can correlate the tax with the economy like supply and demand, with the below example you can get some essence of it :

Primarily through their impact on demand. Tax cuts boost demand by increasing disposable income and by encouraging businesses to hire and invest more. Tax increases do the reverse. These demand effects can be substantial when the economy is weak but smaller when it is operating near capacity.

The economic activity reflects a balance between what people, businesses, and governments want to buy and what they want to sell. In the short run—focusing on the next one or two years—economic policy has a greater impact on the demand side. When the economy is weak, for example, the Federal Reserve tries to boost consumer and business demand by cutting interest rates or purchasing financial securities. Congress, for its part, can boost demand by increasing spending and cutting taxes.

Tax cuts increase household demand by increasing workers’ take-home pay. Tax cuts can boost business demand by increasing firms’ after-tax cash flow, which can be used to pay dividends and expand activity, and by making hiring and investing more attractive.

Tax policies can also affect the supply of labour in the short run. A cut in payroll taxes could bring some workers into the labour market or encourage those already working to put in more hours. Such supply changes have little effect on output if the economy is operating well below potential. Under those conditions, people have difficulty finding more work even if they want it. If the economy is operating near potential, however, increased labour supply can translate to increased output.

A good tax system should meet five basic conditions: fairness, adequacy, simplicity, transparency, and administrative ease. Although opinions about what makes a good tax system will vary, there is general consensus that these five basic conditions should be maximized to the greatest extent possible

Point B :

Impact of tax -

• Raise revenue for the government. The main purpose of the tax is to raise income for the government which can lead to higher spending on health care and education. The impact depends on what the government spend the money on. For example, it may be necessary public sector investment (repairing roads) or it could be to fund shortages in pension funds)
• Less discretionary income. Those paying income tax will be left with less discretionary income to spend after income tax has been deducted. This is likely to lead to lower levels of household spending and lower levels of household saving. However, if the government spend the tax revenue – overall aggregate demand (AD) will not be affected.
• Incentive effect. Higher-income tax reduces the take-home pay and can reduce the incentive to work. Either workers chose not to do overtime or even leave the labour market altogether. However, there are two conflicting effects of higher tax
  • Substitution effect. Higher tax leads to lower wages – and work becomes relatively less attractive than leisure. The substitution effect of a higher tax is that workers will want to work less.
  • Income effect. However, if higher tax leads to lower wages, then a worker may feel the need to work longer hours to maintain his target level of income. Therefore, the income effect means that higher tax may mean some workers feel the need to work longer.
  • This means there is no guarantee of the impact of higher tax – it depends whether the substitution effect is greater than the income effect.
• Laffer curve. The Laffer curve is an analysis which suggests at some tax rates, higher income tax will reduce incentives to work and actually leads to lower tax revenue.

Point C:

Following Universal principles of taxation i.e. Canons of taxation is the best recommendation for successful implementation of new tax policies:

Canon of Equality: Equity or social justice demands that the rich people should bear a heavier burden of tax and the poor a lesser burden. Hence, a tax system should contain progressive tax rates based on the taxpayer's ability to pay and sacrifice.

Canon of Certainty:

The certainty aspects of taxation are:

1. The certainty of effective incidence i.e., who shall bear the tax burden.

2. The certainty of liability as to how much shall be the tax amount payable in a particular period. This the taxpayers, as well as the exchequer, should unambiguously know.

3. The certainty of revenue i.e., the government should be certain about the estimated collection of revenue from a given tax levied.

Canon of Economy: Every tax has to be contrived as both to take and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state

Canon of Elasticity:

Taxation should be elastic in nature in the sense that more revenue is automatically fetched when the income of the people rises. This means that taxation must have built-in flexibility.

Canon of Productivity:

This implies that a tax must yield sufficient revenue and not adversely affect production in the economy.

Canon of Simplicity:

This norm suggests that tax rates and tax systems ought to be simple and comprehensible and not to be complex and beyond the understanding of the layman. This is what is rarely found in the Indian tax structure.