The Only Fair Means of Taxation is Direct Taxation - Indirect Taxation Has No Part to Play in Today's Society - Essay Example

THE ONLY FAIR MEANS OF TAXATION IS DIRECT TAXATION. INDIRECT TAXATION HAS NO PART TO PLAY IN TODAYS SOCIETY- A CRITICAL EVALUATION Word Count:1696 The Only Fair Means of Taxation is Direct Taxation. Indirect Taxation has no Part to play in Todays Society 1. Introduction The issue of direct taxation 1 versus indirect taxation2 has been one of the oldest controversies in public economics. Based on the optimal theory of tax structure, many economist argue that the tax revenue yields from the direct taxes like income tax are much higher than those from indirect or commodity taxes(Barone,1912;Borgotta,1921;Joseph,1939).Moreover, according to this argument, any second best optimum can be achieved by direct taxation alone, for weakly separable preferences in labour supply and produced goods(Atkinson and Stiglitz,1976,1980 etc).On the other hand, other hand, there has been a shift towards the indirect taxation in many nations .Economist have shown that the argument of Barone(1912) etc might be true for a partial equilibrium setup with a unique individual but need not be valid under general equilibrium setup with heterogeneous individuals(Friedman,1953).The debate remains unsettled. In this context, this essay makes a critical evaluation on the argument that direct taxation is the only fair means of taxation while indirect taxation has no part to play in today’s society based on the UK tax system. The critical evaluation is done from the points of view of principles of good taxation system, four current taxes in UK and the necessity of raising taxes in UK. In the second section, the discussion is done based on the principles of good taxation system, in the third section, discussion is done based on four current taxes in UK and the fourth section does the discussion based on the necessity of raising taxes in UK. The fifth section concludes the essay. 2. Principles of Good Taxation The four canons of taxation developed by Smith (1776) which are still widely accepted are the low cost3 of collection relative to the yield called canon of economy, certainty of the timing and amount to be paid to the payer called canon of certainty, convenience of the means and timing of payment to the payer called canon of convenience and the taxes to be levied based on the ability to pay called canon of equality. In addition to these, the other criteria added to these by modern economists include efficiency of taxes4, productivity of taxes5, elasticity6,simplicity7, diversity8, compatibility of taxes with foreign systems and automatic adjustability of taxes to changes in the rate of inflation (Joint Committee on taxation,1995;AICPA,2001; James and Nobes ,2008). Thus based on all these criteria, taxes can be evaluated according to efficiency, incentive, equity and macro considerations. The direct taxes mainly include the conventional income taxes and also taxes on assets and wealth while indirect taxes include Value Added Tax(VAT) and taxes on excise, customs, tariffs etc(Vazquez etal,2009). In UK, there is a clear distinction for levying income taxes on different persons based on their residency status. There are many personal allowances in UK to reduce the tax burden. At the same time, some studies show that there is no clear differentiation between avoidance and evasion in UK, which goes against the principles of fairness (Chittenden and Foster, 2008). Direct taxes leave people with no choice while indirect taxes leave people with choice. At the same time, since most people are unaware of how much they are paying in indirect taxes, it goes against the principle of transparency. The PAYE system in UK has helped to avoid the administrative and compliance costs associated with the direct taxation in UK, which has proved the UK tax administration to be quite cost effective(Adam and Browne,2009).The argument in favour of indirect taxes is that since they can be changed more easily than direct taxes, economic policy makers are given more flexibility while setting fiscal policy(Adam and Browne,2009).At the same time, it is argued that there can be uncertainty regarding revenue from indirect taxes during recession times or low inflation(Vazquez etal,2009). The recent data for UK income tax shows rising average tax rate as a percentage of gross income, which shows progressivity of income tax rates (UK National Statistics, 2008). Moreover while data shows very slow increase in the number of tax payers in the country, very rapid rise from 3% in 1978-79 to 12% in 2008-09 was seen for higher rate tax payers (Adam and Browne, 2009). .This can have income redistribution effects. The progressivity of taxation in UK can act as an automatic stabilizer to the economy from a macro perspective as the increasing tax payments eat into the disposable incomes of the people (Dromel and Pintus, 2008). Many indirect taxes are more regressive than the direct taxes which make the distribution of income more unequal and less equitable. Moreover, the rise in indirect taxes can lead to cost push inflation leading to rise in inflation expectations ((Dromel and Pintus, 2008). One of the main advantages of the UK income taxation system is the separate taxation of family members rather than joint taxation since 1990.This in addition to the flat tax level has many benefits in terms of incentive and macro considerations particularly for women. The trading losses can be carried forward to be netted against future income profits in UK, which has favourable incentive effects (Adam and Browne, 2009).In terms of incentive effect, indirect taxes are argued to provide an incentive effect to save and thus avoiding tax. At the same time, higher indirect taxes may affect lower income households who are least able to save(Dromel and Pintus,2008).Another argument is that indirect taxes are less likely to distort the work-leisure choices of people and hence only have less negative work incentives. At the same time, the evidence on this is not clear and higher indirect taxes may create an incentive to avoid taxes through bootlegging as in the case of cigarette duty avoidance (Dromel and Pintus, 2008). 3. Current Taxes The following figure and table 1 shows that bulk of the tax revenue to the UK government comes from income tax, VAT and national insurance contributions .The trends however, show the rising importance of VAT and national insurance contributions relative to income tax in UK. Among the indirect taxes other than the VAT, fuel duties, tobacco duties and alcohol duties contribute to the bulk of the tax revenue. The share of revenue from VAT has almost doubled in the recent years while the share from other expenditure taxes has reduced substantially mirroring the trends in the developed world (Adam and Browne, 2009).There have been significant changes in the income tax rate structure with the cut in basic rate from 30 to 20 percentage, abolishing of start tax rate, top rate cut to 40 percent from 83 percent, abolishing married couple allowances and introduction of many tax credits. Moreover the VAT tax rates also have been doubled since 1990 in UK from 8 percent to 17.5 percentages. Among the other indirect taxes, fuel and tobacco duties have increased significantly wine and spirit duties have decreased significantly(Adam and Browne,2009). Source: Riley(2006) Table1:Source of Government Revenue 2008-09 Forecasts Source: Adam and Browne (2009) 4. Necessity of Raising Taxes The United Kingdom has one of the most competitive income tax rates in comparison with other EU countries. Its higher tax rate stands at 40%, which is in comparison with Sweden at 61%, Belgium and 53, of France at 51, the Netherlands at 52%, and Germany at 45% (UK Trade and Investment, 2009). Though the income taxes are considered to be progressive in UK, it is seen that the progressivity has been reducing over years. Before 1979, the top tax rate was 83 percent which is now reduced to 40 percent which cannot be considered as a great progression (Adam and Browne, 2009) .So to get a more equal distribution of income, the arguments are to either increase the top rate more than 40 percent or to increase tax free allowance for people or to reduce the marginal tax rates for households (Riley, 2006). KPMG (2009) shows that a bigger increase of top marginal rate to 50 % on personal income is announced by the UK government in 2010. It is argued that higher indirect tax rates can reduce the starting rates of income tax. However, there is no clear evidence on this regard and higher indirect taxes are likely to create an incentive to avoid tax through boot legging and also can create cost push inflation (Riley, 2006). 5.Conclusion The essay shows that in terms of principles of good taxation, the direct taxation can be considered as better compared to indirect taxation in terms of efficiency, incentive, equity and macro considerations in UK. However, in terms of revenue yield that is obtained to the UK government, though income tax rate contributes to the bulk of the revenue, the share of VAT contribution to the tax revenue has been doubled. Moreover a shift is seen from the income tax to the VAT and national insurance contribution in UK mirroring the trends in the developed world. In terms of progressivity, the a decreasing progressivity trend is seen in UK direct taxes when compared to years before 1979 which shows the need for increasing the tax rate for higher income households. At the same time there is no clear evidence seen for the argument favouring the rise in indirect taxes. Overall, it can be concluded that direct taxation indeed provides better means of taxation while it cannot be considered that indirect taxation has no role in society. Indirect taxation has its role in society which has been increasing in the recent years. BIBLIOGRAPHY Adam S and J Browne (2009): “A Survey of UK Tax System”, Briefing Note No.9, UK: Institute for Fiscal Studies. Atkinson, A.B., Stiglitz, J.E., (1976). “The design of tax structure: direct versus indirect taxation.” Journal of Public Economics 6, 55– 75. Atkinson, A. B., “Optimal Taxation and the Direct versus Indirect Tax Controversy,” Canadian Journal of Economics 10 (1977), 590–606. Atkinson, A.B., Stiglitz, J.E., (1980). “Lectures on Public Economics.” ,New York: Mc-Graw–Hill,. AICPA (2001): “Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals”, New York. 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