Typologies of Tax Systems
Taxes Opens in new window can be classified along three dimensions depending on:
- who collects them,
- how they are collected, and
- who pays
Who Collects Taxes?
Taxes can be levied by the central government, state governments (especially in federal countries, e.g., Länder in Germany, cantons in Switzerland, provinces in Argentina), local governments, and social insurance administrations.
However, the administration that levies that tax may not be the one that decides on it or benefits from it. For instance, local taxes can be levied by the central tax administration on behalf of local authorities.
In federal countries (like Germany, Switzerland, Spain, or Canada), the central government often receive less than half of total tax receipts.
In France, the largest part of the revenue is received by social security funds, whereas in Denmark or in the United Kingdom, social security is managed by the central government, along the lines of the “Beveridgian” system (where social security benefits are funded by general taxation).
The distribution of taxes between the central and local governments raises issues of tax autonomy and tax competition Opens in new window, in the context of Oates’s equivalence.
On the one hand, it is desirable that taxes be raised at the local level to make local governments financially responsible and to allow them to develop policies that are consistent with local preferences (tax autonomy).
On the other hand, there is a risk that autonomy would allow wealthy localities to become even wealthier because they are able to attract more individuals and companies through cutting taxes (tax competition), whereas poor localities would need to raise tax rates because the tax base is limited and because they have higher social expenditures.Central governments therefore frequently organize redistribution across localities.
The level of this redistribution is a contentious issue since it affects the trade-offs between efficiency (of local public choices) and equity (between localities).
How Are Taxes Collected?
Another classification of taxes relies on the way they are collected.
A direct tax is a tax levied on income (or wealth) whatever the use of this income (or wealth).
Direct taxes include:
- For households, the personal income tax (a tax on labor and capital income that can be paid directly by the households or levied by the employers), inheritance taxes, property taxes, and wealth taxes;
- For companies, the corporate income tax and local business taxes such as the German Gewerbesteuer, the French Contribution économique territorial or the Italian Imposta regionale sulle attività productttive (IRAP).
In contrast, an indirect tax is levied on the use of income, mainly on consumption.
- Typical examples include taxes levied on imports of goods and services (import duties), the US sales tax and the European value-added tax (VAT), both of which are borne by consumers when they buy a good or a service.
- Excise taxes (i.e., taxes on specific products such as cigarettes or alcohol) are other examples of indirect taxes.
- Finally, environmental taxes (including energy, transport, and pollution taxes) are also indirect taxes.
The third category of taxes covers social insurance contributions that are paid both by employers and employees on the basis of the wage bill.
Although they can be considered as direct taxes, social insurance contributions are generally treated separately due to the link between individual contributions and benefits.
In Denmark, Australia, New Zealand, and Canada, direct taxes represent 60% or more of taxation. Conversely, Central and Eastern European countries, Greece, and Turkey rely more heavily on indirect taxes.The disparity of tax systems embodies a differentiation between Bismarckian systems (Germany, Australia, France, the Netherlands) and Beveridgian system (the UK, Denmark, Ireland).
In the first ones, inspired by the scheme introduced by German Chancellor Bismarck in the 1880s, social insurance benefits are treated as deferred wages; they are therefore financed primarily by social contributions based on wages, and each employee knows that what he or she will receive when unemployed or retired will be proportional to his or her contribution.
In the second system, introduced in the United Kingdom after William Beveridge’s 1941 report, social benefits are viewed as public transfers whose objective is to ensure that the most deprived receive a minimum level of income; they are financed primarily through taxes and there is little link, at the individual level, between contributions and benefits.With time, the contrast between the two schemes has tended to fade away:
Beveridgian systems have introduced some insurance schemes, whereas Bismarckian ones have been altered by the capping of unemployment benefits or complemented with the distributive transfers.
In some countries, there has also been a shift from social insurance contributions to indirect taxes, notably environmental taxes (Denmark, Sweden), and VAT (Denmark, Germany).
Since the mid-1960s, the share of indirect taxes in total tax revenues has tended to decline in advanced countries, but this aggregate evolution results from the opposite trends of declining excise taxes and rising VAT revenues. In fact, in world of mobile capital and labor income bases, VAT has been increasingly regarded as an efficient, nondistortionary way to raise revenues.
Another evolution since the 1980s has been a fall in the share of PIT revenues (over total tax revenues) from 30% in 1985 to 24% in 2015. Governments in many countries have reduced politically sensitive personal income taxes while increasing both social insurance contributions and VAT rates.
As highlighted by Tony Atkinson (1977), unlike indirect taxes, direct taxes can be personalized (i.e., adapted to the taxpayer’s characteristics). For instance, the PIT depends on the household’s characteristics and on the nature of income received (labor income, capital income, pensions, or social transfers).
Similarly, the corporate income tax (CIT) depends on taxable profit that takes into account recent investment or R&D expenditures; in some countries, the tax rate is also different depending on the size of the company or on the use of profit (whether it is distributed as dividends or reinvested in the company).
In contrast, indirect taxes are levied on anonymous transactions: any taxpayer thus faces the same tax rate. It follows that only the direct taxes should be used for redistribution purposes.
Indirect taxes are devoted to allocation functions, which consist both in financing the provision of public goods and in correcting market distortions. Note that these two objectives are largely incompatible because what is aimed at is stable tax base in the first case and a shrinking one in the second.
This calls for using distinct instruments: on the one hand, a broad, inelastic base from which revenues can be raised without too many distortions; on the other, an elastic tax base to which a high tax rate can be applied.
Economists are generally reluctant to classify taxes according to the person who administratively pays the tax and makes the transfer to the tax administration—the taxpayer. For instance, they are not at ease with adding up employers’ social contributions and CIT on the grounds that both are paid by corporations.
Similarly, they prefer not to aggregate personal income taxes raised on labor income and those raised on capital income. They prefer to attach each tax to its tax base.
Accordingly, a third classification of taxes distinguishes three categories: labor, capital and consumption.
For instance, labor taxation covers social insurance contributions paid both by employers and employees and lumps them together with the part of personal income taxes paid on labor income.
Taxes on labor account for the bulk of between-country differences in total taxation: those countries with the highest total tax burden are also those where labor taxation is the heaviest. The distribution of taxation among the three tax bases also depends on development levels. Developing countries tend to rely more heavily on indirect taxation.
The question of who pays taxes raises the twin question of who does not pay taxes (i.e., that of tax avoidance). For 2015, the European Commission estimated the gap between expected and effective revenues from the VAT Opens in new window (the “VAT gap”) to be close to 13% of net VAT receipts on average, with large variations across the Member States (up to 37% in Romania, but close to zero in Sweden).
Part of the VAT gap is related to corporate insolvency or bankruptcy (i.e., companies that are in fact unable to transfer the VAT they have collected from their customers to the tax administration).
Part of the gap, however, comes from fraud through unreported sales, failure to register (small businesses), misclassification of commodities (when different rates are applicable), omission of self-deliveries, nonremittance of tax collected (for instance, through strategic bankruptcy), and imported goods not brought into tax.