Friday, February 17, 2012

Fair Tax

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What is fair tax?

“Theres only one kind of tax that would please everybody -- one that nobody but the other guy has to pay”.

-- Earl Wilson


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A fair tax system might contain two basic ingredients First, each person should pay his fair share of the costs of government; second, the government should only tax real value, not fiat money inflation.

What constitutes fairness in taxation? In the first place, the proceeds should only be used to pay legitimate costs incurred by a government. In the second place, since every person receives theoretical benefits from the functions of the state so every person should contribute on a relatively similar scale as his neighbor. A cardinal rule in taxation should require those people who benefit from government activities to pay.

This essay will explore the importance in a fair tax and the elements (criterions of a fair tax) that constitutes equitable taxation. The essay will then conclude after analyzing the distributional effects of implementing taxation and ways to reduce the undesirable effects, i.e. Tax capitalization.

The importance of fair taxation

A fair tax is considered where the redistribution of income via taxation and the transfer payment are proportional (Iyer, 18). This view of redistribution of income is a widely held view that many consider equitable; representing one of the more basic and fundamental element in the importance of fair taxation. One of the most important requirement for an equitable tax is the preservation of horizontal equity (people with a similar ability to pay taxes should pay the same amount) and the preservation of discrimination of vertical equity (people with a greater ability to pay should hand over more tax to the government than those with a lesser ability to pay) when it comes to proportional distribution of taxation. And should the preservation of the strata be breached due to a perceived unfair tax, catastrophic events might suffice rendering potential economic and political problems.

Elements of fair tax

There are three criterions to examine if a tax distribution is fair. Firstly, the endowment based criteria which gives allowance for the inequalities in abilities between individuals (James and Nobes 00). This seemingly ‘natural’ distribution of income is deemed to be fair. However these kinds of “conscience” styled income derivation has the tendency to promote unequal-ness through monopolist tangents, gifted or inherited wealth and to some extent, the result of superior education; and though it can be modified to take into account these variables, a relaxed government might deem this to be too high a governance cost.

Next, a more important criterion is the equity based criteria which advocate that all individuals are of equal worth and therefore must be allowed equal welfare(James and Nobes 00). It suggests that a fair tax should first determine the basis on which taxpayers are to be extracted from. The equity criterion calls that tax payers should be taxed according to their ability to pay, either from their income, expenditure or wealth, which are determined to be measurable. The latter two attributes due to intangible variables within their sphere may induce unfair taxation, therefore income as a basis for taxation is perceived to be the best approach.

The Equity criterion has two theories, which are the benefit approach as well as the ability to pay approach (James and Nobes 00). The benefit approach states that the tax burden should be divided among the benefits gained from the government expenditures which are funded by the taxation. This approach encompasses the entire government expenditure offering a rule of fair budgeting rather than taxation alone.

The ability to pay approach, which is the more common approach to tax equity disregards expenditure benefits and calls for the tax burden to be distributed in a fair manner. Fairness is interpreted as calling for taxation in line with the ability to pay. People with equal ability should pay an equal amount (the concept of horizontal equity), while those with higher abilities should pay more (the concept of vertical equity). The distribution of the tax burden is thus to be based on a fairness norm rather than to be derived from a premise of entitlements (James and Nobes 00).

The last criterion in seeking a fair taxation system is by striving for the greatest utility criteria for the greatest well-being for the greatest number of people using the sacrifice approach (Young 10). This approach is applied to the ability to pay principle of equity taxation. The first suggestion is equal absolute sacrifice where payers contribute the same absolute level of utility, while a second suggestion is equal proportional sacrifice where payers contribute same proportion of total utility. The third and final suggestion is equal marginal sacrifice where there is a minimization on the total sacrifice of utility. This is not based on individual sacrifice but on the utilitarian concept of minimal aggregate sacrifice (Young 10).

Equal sacrifice is the dominant principle in distributive justice in taxation. This approach is compatible with principles of progressiveness and fairness which drive the political debate. It is not only useful for assessing tax fairness, but also for evaluating fairness in income changes. Therefore the relationship between income and utility advocates progressive taxation and asserts that from each according to his ability to pay, to each according to his need. In other words, those who produce more value should pay progressively greater taxes.

Distributional effects of tax imposed

To devise a fair tax, it is important to analyze the distributional effects of the tax to be imposed. These effects can be classified into direct and indirect effects of taxation. One important direct effect of implementing tax is redistribution of income resulting in reduced poverty and reduced unemployment.

An indirect effect on expenditure taxation is tax shifting which is the difference between statutory incidence and economic incidence of a tax (James and Nobes 00). An effective or ‘economic’ incidence result where consumers bear the burden of taxation which is caused by the high income earners is known as statutory incidence. The tax incidence borne by the consumers affect the price elasticity’s of supply and demand, therefore both the supplier and the consumer bear some of the tax. This elasticity’s on supply and demand affects on both sides of the market, on substitutes and complements. However, Tax shifting offset the market distortion of externalities with the government distortion of taxation. The distributional effects are caused by the various prices, wages, and profits and so on of different relative importance to different people (James and Nobes 00) .

An extreme example of tax incidence is the effect of capitalization where taxes affect the capital value of assets. This happens because the value of an asset reflects the income (both pecuniary and non-pecuniary) that the asset is expected to yield (James and Nobes 00). It means that a tax change will alter the expected yield of the asset causing a change in its market price. In other words, the tax has been capitalized.


In order to introduce a fair tax into the economy. The government must first create the infrastructure to ensure the administration system to cater to the smooth running of the tax system as well and the resources to educate the public. People have adverse attitudes towards taxation if they perceive that the tax is not a ‘fair’ tax and they are being exploited. These behaviors may be caused by high tax rates, imprecise laws, insufficient penalties, and inequity. Two undesirable effects of behavior from people whom have negative feelings towards the tax system will either avoid tax or evade tax altogether.

Tax avoidance is a reduction or minimization of tax liability by lawful method while tax evasion is the reduction or minimization of tax liability by illegal methods. Therefore a fair tax system should work towards imposing control to cover loop holes where people seek to avoid or evade tax.

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