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CTOs Talkpoint: What to Tax?

CTOs Talkpoint: What to Tax?

CTOs Talkpoint: What to Tax?

Whether we look at developed countries, with aging populations and growing health and social security bills, or at developing countries needing funds to finance the UN Sustainable Development Goals, it is clear that there is pressure to widen and deepen the tax base. Furthermore, it is often said that current tax systems — particularly corporate tax ones — are no longer fit for purpose in the 21st century. And in some countries the question of ‘fair taxation’ is a hot topic.

What is the purpose of tax?

Before looking at some of the issues, it is worth thinking about the purpose of tax and the principles of a good tax.

There are no exhaustive definitions but the following is a rough guide:

  1. Raising revenue: It is often said that tax is the price we pay for a civilized society; that is, tax pays for the social goods we desire including health, education, infrastructure and security.
  2. Redistribution: The inherent inequality in society is undeniable and tax is one way of addressing it. This may be directly, for example, by providing social security payments, repayable tax credits or family allowances. Alternatively, it may be indirectly, through a progressive tax system where the richer bear a greater tax cost.
  3. Changing behavior: There are debates about whether a tax should be used to help change behavior. Some argue it creates inefficiency and tax is not the best tool for addressing such issues. However, many countries use tax at least partly in this way. Firstly, tax can be used to address ‘market failure’. An example would be providing accelerated or enhanced tax depreciation for research and development where it is considered that market forces do not incentivize these activities sufficiently. Another example is green taxes based on the principle that ‘the polluter pays’. But there are also so-called ‘sin taxes’ — such as on tobacco, alcohol and gambling — which are designed to discourage certain activities that society considers less desirable.
  4. Supporting the economy: To a certain extent, fulfilling this objective relies on how the tax law is formulated and how tax receipts are spent. Supporting the economy can include encouraging investment, creating employment, attempting to stabilize prices in the short term, controlling cyclical fluctuation of the economy and assisting the balance of payments. 

Principles of a good tax system

Discussions on the principles of a good tax system often start with Adam Smith’s The Wealth of Nations. These can be summarized as:

  • Proportionality: The tax burden should be linked to the taxpayer’s ability to pay. This is sometimes called ‘vertical equity’. An allied principle is ‘horizontal equity’ — that is that taxpayers in the same position should bear the same burden.
  • Certainty: Taxpayers should, as far as possible, havecertainty over the amount they will have to pay.
  • Convenience: Tax should be levied at a time and in a way that is most convenient for the taxpayer.
  • Economy: The cost of collecting the tax should be as low as possible.

It is, of course, possible to add more principles. For example, in today’s environment, the following are important.

  • Efficiency: It could be said this is a subset of Certainty. It is, however, important that taxes are designed in a way that they cannot be avoided, or indeed evaded, easily and they should not distort business decisions.
  • Simplicity: With tax codes growing ever more complex, this is an important issue — and clearly linked to Certainty, Convenience, and Economy.
  • Sustainability: Generally speaking, a tax should be on a base that does not deteriorate over time — unless it is intended to be temporary or to reduce certain undesirable behaviors. 
  • Stability: In order for a government to plan expenditure, a good tax should generally not be volatile — although there are arguments for having volatile taxes that can act as an automatic stabilizer.
  • Consistency: Individual rules should fit coherently with the overall tax system in a country, and there are also taxes, such as a financial transaction tax, that may not be efficient unless it applies regionally or globally.
  • Gender neutral: There is a growing body of research showing that some tax systems — for example, VAT — tend to have a greater impact on women.

How does the theory translate into practice?

If the answers to what and how to tax were obvious, somebody would have produced a blueprint for a perfect tax system. That this does not exist is due in part to the fact that different countries have different social, cultural and economic characteristics, and there are varying individual views on how to balance all the factors and set priorities.

Tax on the creation of wealth

It is often noted that it is becoming harder to assess and collect corporation tax in an increasingly global environment with mobile capital. Furthermore, there are concerns that the current system allows multinational enterprises (MNEs) to shift profits from high tax to low tax jurisdictions. This undermines not only the principle of redistribution but also the one of horizontal equity and makes corporation tax an inefficient tax. A proposed solution is to adopt formulary apportionment of global profits. However, formulary apportionment carries its own difficulties and suggests, borrowing from Winston Churchill’s dictum, that the current arm’s-length principle may be the worst of all systems “except the rest of them”. The solution may be to improve the current rules instead of completely changing the system.

The impact of digitalization increases the pressure on the corporate tax system, data revolution is remaking capitalism in radical ways and innovative approaches to data taxation may be needed. The real issue is not more to do with identifying the location of investment rather than the use of digital technology. Nevertheless, many countries are now introducing specific digital taxes with the EU Commission, in particular, making this part of its ‘fair tax’ agenda. Blockchain developments will enable users to own and trade their data, which may make it a taxable commodity in the future. Will blockchain assist with certainty, convenience and economy in tax collection?

The debate about taxing corporations is complicated by the fact that there is no clarity about who ultimately bears the cost. Corporation tax should be a charge on the capital invested, and so should apply to the investors; but it is often argued that a significant proportion is borne by the consumers or employees. Economists generally agree that taxing employment creates a drag on the economy; and whether it is possible to move part of the tax burden from employment to capital. This would be in line with the principle of proportionality as capital is held disproportionately by the well-off. However, taxing capital can also adversely affect employment, and there are concerns that it is more mobile than employment, making it less efficient to tax.

Tax on holding wealth

A potentially efficient tax would be on the potential annual rental of all land, and this would also recognize that land is a public asset and should not be the absolute possession of private individuals. While they tend to be the least popular of taxes, they are particularly appropriate for financing local government. The emphasis however should be on annual property taxes rather than transactional taxes.

There is a proposal to replace traditional inheritance tax rules with a lifetime allowance and restricting pension contribution tax relief to a flat rate so as to make the tax system more proportional. However, in practice net wealth taxes have been found to create issues of neutrality, efficiency and equity; the best approach to taxing wealth could be through annual property taxes.

Tax on spending wealth

Many economists would argue that moving to taxing consumption is the most efficient form of tax as it is least distorting of behavior. However, this is widely considered to be regressive. There are suggestions to make consumption taxes more progressive; while some may argue it may be more efficient to lower the rate but broaden the base and then use the revenues generated to drive progressivity through other parts of the tax system. When it comes to digital transactions, the issue is not what to tax but who should collect it? Another key issue is: Should indirect tax be applied to the growing number of consumer to consumer transactions?

Tax and sustainability

Finally, no review of what to tax would be complete without looking at green issues and how green taxes can be used to improve health, protect nature, increase tax revenues and drive competitiveness and innovation. Green taxes, though, do have a sustainability paradox, the more successful they are at changing behavior, the less revenue they generate.
 

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