What are the principles of good taxation?

Taxation: one of the clearest manifestations of the powers of a public authority.

It has existed since the earliest forms of recorded government in history: from ancient Egypt, when the pharaohs levied taxes in the form of shares of agricultural production and labour; to ancient Rome where farmers were required to pay a tenth of their production (decima) to the tax administration (aerarium); and even in Medieval Europe, where a similar taxation system became one source of financing for the Church.

Nowadays, governments have developed more sophisticated systems and processes for defining who is taxed, what is taxed (the ‘tax base’), how much is taxed and which personal conditions of the taxpayers should be taken into account. But what are the principles that should underpin taxation and how do these impact our daily lives?

Firstly, while it’s true that it’s typically implemented through the coercive power of a public authority, taxation should not be imposed arbitrarily. Indeed, many modern institutions include some restraints on the uncontrolled levying of taxes, with parliament usually having to approve the executive’s proposals (for example, in 1628, the Petition of Rights introduced restrictions on the Crown on non-parliamentary taxation in England). Rather, there should be careful consideration of how the forced acquisition of money affects taxpayers: on the one hand, taxation provides a fundamental source of income for running the government and providing public services; on the other, taxation reduces individual disposable income and business profits and could therefore have a negative impact on decisions about work, consumption and investments.

Who was Adam Smith?

The principles of good taxation were formulated many years ago. In The Wealth of Nations (1776), Adam Smith argued that taxation should follow the four principles of fairness, certainty, convenience and efficiency. Fairness, in that taxation, should be compatible with taxpayers’ conditions, including their ability to pay in line with personal and family needs. Certainty should mean that taxpayers are clearly informed about why and how taxes are levied.

Convenience relates to the ease of compliance for the taxpayers: how simple is the process for collecting or paying taxes? Finally, efficiency touches on the collection of taxes: basically put, the administration of tax collection should not negatively affect the allocation and use of resources in the economy, and certainly shouldn’t cost more than the taxes themselves.

The sound basis of good taxation today

Adam Smith’s principles of good taxation form a sound basis for taxation today, however, they’re not always followed. Sometimes tax systems hit certain categories of taxpayers or kinds of consumption while leaving others relatively untouched. Sometimes tax systems lack transparency, imposing charges on some goods (eg, fuel excise) without any explicit indication on our bills.

Sometimes taxpayers are burdened with administrative tasks, for example filing yearly tax returns online. Sometimes the tax administration does not, or cannot, apply regulations or prosecute those who evade taxes in a cost-effective manner.

Taxation and the economy

How can governments levy taxes while minimising negative effects on the economy? Generally, taxes (on income, on production, or on the consumption of goods) have distortionary effects: they alter the decisions that individuals and businesses would make if the taxes were not in place.

Excises

For example, excises (taxes that are levied on the production of goods) often cause producers to increase the prices of goods, passing the burden of taxation on to consumers. When prices go up, there’s less demand, so businesses earn less income and consumers enjoy less consumption.

Personal income tax

In addition, personal income tax reduces consumer purchasing power: consumers purchase fewer goods than they would do without the income tax, generally cutting luxury and unnecessary items first, and thereby hitting some industries more strongly than others.

Economic development and growth

Taxation can also have important effects on economic development and growth. When international financial markets are liberalised, for example, capital tends to flock towards countries where tax regimes are more advantageous.

When personal income tax is relatively high, individuals may prefer spending their time on recreational activities rather than on additional work. When taxation on savings (including taxation on financial rents and on real estate) is relatively high, individuals may prefer consuming their income today rather than putting part of it aside for the future.

Overall, the effects of decisions that individuals and businesses make may result in less money being available for investments and less effort to undertake business activities.

If you’d like to learn more about understanding public financial management, check out the full online course from the University of London, below.