Tax Policy

What Is Taxation About?

Tax policy consists in setting, within the annual budget, the rate and the base of each tax. For instance, the government can decide to increase the consumption tax by one percentage point (a decision on the rate) or to exempt some items from this tax (a decision on the base).

Tax revenues depend on the combination of rates and bases. It is possible to maintain a given level of revenues through simultaneously cutting the rate and broadening the base (this has been the general trend recently, as we shall see).

In most cases, choices on the rate and on the base interact: a higher tax rate tends to reduce the tax base.

Additionally, tax bases generally depend on economic activity: for instance, for a given definition of rates and bases, a downturn in, say, consumption spending will automatically reduce the income accruing to consumption taxes. Hence, tax revenues are often difficult to predict.

Governments seldom charge for their services.

Except in specific areas such as museums, swimming pools, or universities, these services are generally provided free of charge. Think about scientific research, defense, or diplomacy. Those are public goods; it is therefore impossible to identify precisely which citizens benefit from them and to let them pay for their consumption. Such government services have to be financed through taxation (i.e., compulsory contributions by households or corporations).

Not all tax-financed government services are public goods. Think of schooling: it would be possible for the government to charge for its provision, but the common practice is to finance it at least partly through taxation. It is by their vote that citizens can express preferences regarding the level and quality of public services provision and the corresponding level of taxes.

The problem is that taxes generally distort relative prices. For instance, the personal income tax (PIT) is paid by households on their labor income. This increases the relative price of labor as compared to leisure and may therefore change the labor supply. Such distortions may affect welfare and gross domestic product (GDP) growth. Consequently, there is a trade-off between the provision of public goods (which in many cases, such as education, security, or infrastructure building, is expected to have a positive impact on welfare and growth) and the desire to reduce taxation in order to limit price distortions.

From a pure efficiency standpoint, public services should be financed through lump sum taxes (i.e., taxes that are levied in equal amounts on every citizen independently of their activity, consumption, or income) because such taxes do not distort work, saving, and consumption decisions. However, such taxation (experimented with by Margaret Thatcher’s government in 1979 through the so-called poll tax2) is questionable from an equity standpoint since the poor pay relatively more as a percentage of their income than the wealthy. In order for the burden of taxation to be distributed in an equitable way, and even more so when income redistribution is a policy objective, taxes have to be proportional or more than proportional to income, which inevitably introduces economic distortions.

Because it is at the heart of the efficiency–equity trade-off, and because it is the simplest way to redistribute wealth among citizens, tax policy has always and everywhere been hotly politicized, often at the cost of overlooking essential economic considerations. Tax policy is a matter for political decision and is in all democracies a prerogative of parliaments. As we shall show in this entry, though, economic analysis can greatly contribute to the design of efficient taxation systems.