Understanding What a Tax Is
Many people do not understand taxation, yet it is something that affects all our lives on a daily basis. Most elderly persons have been paying tax to the US Inland Revenue Service (IRS) Opens in new window for most of their life, but still finds it so complicated to understand it.
It is a sad fact of life that almost any country’s taxation system Opens in new window is so complex that very few people (i.e. only professionally qualified tax advisers/lawyers, etc.) will understand it completely, and yet the average citizen and business are expected to comply in full with the tax requirements that are applicable to them.
What Then Is a Tax?
It is often difficult to get one’s head round the idea of what a tax actually is, as it comes in many guises.
It is rather like an elephant — difficult to define or even describe, but you know it when you see it. Various attempts have been made to define what a tax actually is, and the list given below is by no means exhaustive.Oxford English Dictionary
A compulsory contribution to the support of government, levied on persons, property, income, commodities, transactions, etc.
Chambers Maxi Paperback Dictionary
A contribution to revenue exacted by the state from individuals or businesses.
Webster’s Online Dictionary
A charge or burden laid upon persons or property for the support of a government.
Johnson, 1913 [1775, p. 2]
A tax is a payment, exacted by authority, from part of the community, for the benefit of the whole. From whom, and in what proportion such a payment shall be required, and to what uses it shall be applied, those only to judge to whom government is intrusted.
James and Nobes [2012, p. 10]
A tax is a compulsory levy made by public authorities for which nothing is received directly in return.
Other definitions can be found in different texts. Words like “compulsory”, “exacted” and “strain”, and the general tone of the last definition suggest that even the idea of a tax or taxation is unwelcome. This then leads us into considering the reasons for imposing tax, if the concept is so unpopular.
The Objectives of Taxation
Generally speaking, the rationale for imposing taxes in a country such as the UK, with a well-developed market economy, derives from the government responsibilities listed below.
1. To raise revenue for the provision of public goods
A pure public good is one that individuals cannot refuse to consume or be excluded from consuming, even if they have no desire for it and do not pay for it.
All members of society can consume such a good without adverse impact on others’ right or ability to consume.
Defense (Defence) of the realm is usually cited as an example of a public good that typifies the above definition. Historically, taxes were raised in many European countries to fund a monarchy and pay for the defense of the realm in times of war.
2. To promote social and economic welfare
Government often provides merit goods, such as health and education. Merit goods, unlike public goods, can be provided privately, but there is merit in the state providing them as everyone benefits from living in a healthy and educated society.
In a similar way, demerit goods, such as alcohol and cigarettes, can be discouraged, often by the imposition of high taxes, because of the health and pollution risks posed to society.
Taxing demerit goods can often present a dilemma for governments. Because such goods are popular, a government can raise considerable amounts of revenue from taxing them, and a lower tax rate might result in a greater tax take overall, but an increased level of consumption.
In a situation where a government provides national health care, free or subsidized, to its citizens, as in the case of the National Health Service Opens in new window funded by the UK governments, then it would conceivably need to expend at least a part of the extra funds raised on additional treatments for alcohol- and tobacco-related illnesses. Revenue raised will then be expended on illness caused by the very products from which the revenue was raised.
3. Economic stability
Government is responsible for preventing high levels of inflation Opens in new window, unemployment Opens in new window and a variety of other problems in order to promote stable economic growth Opens in new window. The taxation system Opens in new window is a means of creating a sound infrastructure for the development of business.
In the years following the economic meltdown in 2008–09 Opens in new window, caused chiefly by banking failures, many Western countries had to use their tax revenues to support the banking system, to enable their economies to continue functioning.
In certain instances (e.g. Greece, Ireland, Portugal and Italy), economic difficulties were so great that support was required from supranational organizations, such as the European Union (EU) Opens in new window and the International Monetary Fund (IMF) Opens in new window.
Each country has its own national tax system and laws, which are different from those of other countries. Indeed, in some countries, such as the USA, each individual state has its own tax system and laws, at the same time as being subject to wider national tax laws.
This is referred to as a federal system Opens in new window. It follows, then that it would make trade and other financial dealings between inhabitants and businesses based in different countries easier if there could be similarity between different national tax systems.
The EU has one of its primary objectives the free movement of goods/services, capital and people between member states. It has also recently devoted much effort to developing proposals for an EU-wide Common Consolidated Corporate Tax Base (CCCTB), aimed at providing a uniform way of taxing company profits.
This at least suggests that harmonization is likely to be an underlying objective of any modern European tax system. However, where the tax system of one country encounters that of another is one of the most complex areas in taxation, and true harmonization may remain an unrealistic dream. However, some taxes show greater evidence of harmonization than others. Value added tax (VAT), for example, is at least a pan-European tax, though rates and implementation vary across different countries.
What Do We Tax?
What is actually taxed is referred to as the tax base. There is a variety of different things that can constitute a tax base, namely income or revenue, capital, expenditure or consumption.
Income may be in certain circumstances very easy to define. For example, it can be the salary or wages an individual earns as a result of his/her employment.
In terms of a business, income is commonly referred to as “sales revenue” or just “revenue” and means the sums generated from sales of the business’s products or services. However, businesses are allowed to deduct certain costs and expenses from their revenue, to derive an overall profit, and it is this profit that is taxed rather than the actual sales figure.
Because income can actually be of many different types (e.g. royalties for an author of books, rental income to a landlord who rents out property, etc.), it is regarded as very difficult to provide an absolute definition — and the UK tax system Opens in new window, for instance, does not attempt to do so, preferring to address income by particular, rather than in general.
The precise meaning of capital depends on the context in which the word is used. In general, it refers to the tangible and intangible assets (e.g. land, buildings, equipment, money, investments, etc.) that businesses use on a long-term basis to do business or that individuals own to support themselves and their lifestyles.
Capital assets can increase or decrease in value and may generate income — which is another type of income in addition to those mentioned above. The income may be a profit on selling a particular asset (though assets also can be sold at a loss), or it may be interest on money deposited in a bank or dividends from shares.
Expenditure usually means the amount of their resources (usually expressed in money) that business and individuals pay out for goods and services they need or desire.
The idea of consumption may be very similar to expenditure, as one of the meanings of “expenditure” is “using up”. However, consumption can also be considered in reference to the destructive use of resources, rather than just the “trade cycle” idea that is implicit in expenditure.
It is important to distinguish between the different types of items, as they can be taxed in different ways and, indeed, may need to be taxed differently to ensure fairness overall.
For example, if an item of consumption is taxed — say, a bottle of spirits — by the imposition of a $2 duty, then the $2 would represent a greater percentage of income for someone earning $10,000 than it would for someone earning $280,000. Such a duty or tax is said to be regressive, and it can easily be seen that it might be less equitable to the $10,000 earner.
However, if the item on which such a tax is imposed is regarded as something that is not necessary for life and health and one has a choice about whether to buy it or not (as one generally would in terms of alcohol), then it is less unfair. Such things can be taken into account when duty levels are set.
Similar considerations might apply to different types of income.
If three men have cash income of $5,000, one as a result of an annual salary, the second from the sale of an antique table, inherited from his father, and the third from dividends on an investment portfolio, should all be taxed in the same way?
One argument might be that they all have cash income of the same amount, and therefore they should be taxed in the same way: they are all in a similar situation. If they were taxed on this basis, this would be an application of what is termed horizontal equity Opens in new window.
However, their income does not arise in the same way: one sum is a result of labor, which will presumably be likewise rewarded in a subsequent year; another results from the sale of an asset, which cannot be repeated — the table can be sold only once; and the third is unearned income from assets.
Looked at this way, the three men are in different situations and should be taxed differently.
Also, someone inheriting and selling antiques or with an investment portfolio may be wealthier than a person earning a salary, so this too may need to be taken into account.
Equally, the $5,000 in dividends might be the only income for a retired, elderly person, struggling to manage, given the inherent tendency of this type of income to fluctuate.
Taking into account differences in situations is referred to as vertical equity Opens in new window, that is, the difference in individuals’ situations should be reflected in the way that their income is taxed.