A Framework for Tax Analysis

I am back to work after my maternity leave and thought I would kick off this new era with a post off with a bit of a tax education piece. I am often asked about how do economists assess taxes and tax systems? How do we choose between different taxes and tax systems? How do we choose between different tax structures?

Well economists have a set of criteria that we use to make our assessments. We typically judge the efficacy of a tax system according to four widely accepted criteria: Equity —“fair” distribution of burden which is usually measured by vertical and horizontal equity; Efficiency—minimize the deadweight loss which is usually driven by elasticity and size of tax; Economic growth—does the tax encourage and support economic growth; and administrative costs—minimize collection and compliance costs.

EQUITY: Most agree that the tax burden should be distributed fairly, that all of us should pay our “fair share.”  However, there is endless debate about what constitutes a fair tax system.  There are essentially two leading theories on which to describe the “fairness” in a tax system. The first is the benefits-received principle. The second is the ability-to-pay principle. I have written about equity in detail before and I refer you to that post for more information.

EFFICIENCY:To economists, efficiency simply refers to the use of resources so as to maximize the production of goods and services. We know that taxes distort economic decisions, they impose burdens, and the excess burden refers to the amount by which the burden of a tax exceeds the total revenue collected.   These are also called dead weight losses (DWL-oddly the name of my softball team when I was doing my PhD).  However, that taxes can actually improve the market outcome.  E.g. Externalities, public goods, etc.  In these cases, taxes reduce the DWL.  This occurs when the market outcome is initially inefficient. Knowing when taxes are good, bad, and in between is vital when designing tax policy.

ECONOMIC GROWTH: The third criteria to assess taxes are their effect on economic growth.  Do taxes encourage or discourage economic growth?  We know that the more developed a country, the larger the government, and the greater the amount of revenue collected via taxes.  So there is a positive relationship, but since taxes distort behaviour, they also reduce growth. For example, taxes go to pay for essential services required to support economic growth such as roads, police, clean water and safe food, the legal system etc.  But taxes also create disincentives to economic growth.  For example, income taxes reduce the willingness of people to work additional hours, to accept risk inherent in investment since gains are taxed, and create “red tape” e.g. the GST on businesses. The key is that taxes are required for economic growth, but they must be carefully balanced and designed to minimize the DWL associated with them. I have written about taxes and economic growth before.

COST: The administrative burden/cost of taxes is part of the DWL of the inefficiencies created by taxes.  This includes time spent filling out forms and record keeping as well as resources to administer and enforce tax laws. Cost could be reduced by simplifying the system.  Simplification, however, can jeopardize the other components of the tax system that we have looked at.  That said a 2800 page Income Tax Act is probably quite inefficient though! One of the costs of taxation that is often overlooked is that of tax avoidance. An individual rightfully go to great lengths to avoid taxation but in most cases these results in deadweight loss as well as inefficiencies.

So there is our big secret. This is how economists assess taxes. And now you can too.

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It’s not fair!

its-not-fair1Any and all parents have to deal with this exclamation on a nearly daily bases. Their toddler, tween, teenager, and even adults utter this phrase on a regular basis when faced with something they don’t like and usually don’t understand: It’s not fair. Usually, the parent mutters under their breath “yah, well, life is unfair” and then proceeds to smile at the child and provide some reassurance like “I know”.

This seems to be what is going on with the income splitting proposal. It is not fair that a single earner pays more in tax than two people making the same amount. Apparently, though it is only unfair if they are seniors or if they have children. For everyone else, it is perfectly reasonable. That complexity, though seems to be a moot issue.

Most of us agree that the tax burden should be distributed fairly and that all of us should pay our “fair share”.  However, there is endless debate about what constitutes a fair tax system.  When someone tells me a tax is not fair, I always ask them to define fair. I have yet to get a reasonable answer to this question. Either the person splutters for a while before caving and realizing that it was more a feeling they had or they eventually storm off in a fit about how I am being unfair.

Economists, however, do define fair quite clearly. In fact, ‘fairness’ or as we say, equity, is a key pillar of assessing taxes. There are essentially two leading theories on which to describe the “fairness” in a tax system.

The first is the benefits-received principle. This principle dates back to Adam Smith and means that taxpayers should pay taxes in proportion to the benefits that they receive from public expenditures. This means that those who benefit the most, pay the most.  If taxes are based on the benefit principle, the people who “enjoy” the largest benefits pay the most for them. For example, people with children would pay more to build and operate schools.  Thus primary beneficiaries of schools are thus taxed in rough proportion to their use of those schools.

The difficulty is that the bulk of public expenditures are for public goods or goods with externalities where the benefits of them fall collectively on all members of society, like public education. Hence, there is no way to determine what value individual taxpayers receive from them. Clearly this is not the definition of ‘fair’ that is being used to support the income splitting proposal, since seniors and families disproportionately benefit from public expenditures.

The second is the ability-to-pay principle. This is a theory of taxation that holds that citizens should bear tax burdens in line with their ability to pay taxes. The ability-to-pay principle has dominated the formulation of the tax policy in Canada. The ability-to-pay principle involves comparing people along two dimensions: horizontally and vertically.

  1. Horizontal Equity: those with equal ability to pay should bear equal tax burdens. Horizontal equity is easy to agree with in principle, but difficult to implement in practice. If two people are identical in every respect, horizontal equity is easy to apply, but how do we compare people who are similar but not identical?  The greatest difficulty arises in working out differences in ability to pay that arise from the state of a person’s health and from a person’s family responsibilities. The Canadian income tax has many special deductions and other rules that aim to achieve horizontal equity in these circumstances.
  2. Vertical Equity: those with greater ability to pay should pay more. This proposition easily translates into the requirement that people with higher income should pay higher taxes, but it provides no help in determining how steeply taxes should increase as income increases. How much more should the rich pay? If horizontal equity is difficult, vertical equity comparisons are impossible.

The ability-to-pay principle can also be tricky when a tax system is based on individuals because individuals form households. Many households pool income and share expenditures. In many households, one spouse supports another. Is it “fair” that a household with one income earner pays more tax than a household with two income earners earning the same income as the one income earner? And that is the question that matters for the income splitting proposal. But equally, is it “fair” that households with dual earners have to shoulder the burden of vast expenses of child care?

The ‘unfairness’ notion with single earners arises solely because of our progressive tax system, yet we all feel that people who earn more should pay more. What is overlooked is that our tax system does try to offset these situations where single earners pay more than dual earners to obtain a more fair outcome. The single earner households do obtain a tax benefit that other households do not. They get the claim the spousal amount. The dual earner family gets to claim a portion of their child care expenses. There are ways we can use our existing system to further address fairness so that lower income households can benefit more without increasing the benefit to higher income households. The spousal amount could be made refundable, the child care deduction could be increased, various tax credits like the CCTB and GST/HST credit could be modified so that single earner households face a higher clawback threshold, and the like. This is much more ‘fair’ than the income splitting proposal that disproportionately benefits wealthy households at the expense of low AND middle income households.

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