MBA (Finance & Investment) – Business Laws & Taxation

Question
The original aim of taxation was to provide the revenue necessary to fund state
functions. At present this is only one of several aims, because the tax system is now
also used for broader socio-economic purposes.
In seeking to explain the current role of the tax system, conventional theorists such
as Charles M. Allen or Musgrave and Musgrave, begin from the proposition that in a
perfectly competitive economy, the problems of production, distribution and
exchange would be solved by the competitive process itself.
The perfectly competitive economy appears, at first sight at least, capable of
functioning in a highly satisfactory way without formal government and so without
taxation.
Requirement:
Why do governments need to impose taxes when we have this self-regulating
machinery for producing the goods and services we require?

Introduction

Taxation is any compulsory levy from individuals, households and firms to central or
local government. The Mauritian economy imposes a wide range of taxes on people.
The system is always evolving as the government seeks to develop and maintain a
tax system that meets objectives and targets.

Perfectly Competitive Economy – No taxes

It is often assumed that in a perfectly competitive economy, the problems of

production, distribution and exchange would be solved by the competitive process
itself. Thus it is assumed that there is no need to impose taxes as there is a self
regulating machinery for producing the goods and services that the society requires.

In other words, taxes are irrelevant in a perfectly competitive economy due to the
following characteristics:

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 MBA (Finance & Investment) – Business Laws & Taxation

a. Consumers’ preferences are well-behaved, meaning that they have a complete

ordering of preferences over the goods and services, their preferences are transitive,
and their marginal rates of substitution are diminishing the more one good is
consumed.

b. Production is well-behaved in the sense that firms earn abnormal profits only in the
short run such that in the long run, all these profits have to be eliminated. Thus only
the most efficient and competitive firms survive in the long run.

c. There can be no externalities.

If all these market and technical assumptions hold, then the allocation of resources
is efficient and there is no need for government intervention in the form of taxation in
order to regulate the economy.

Need for government intervention

However, these 3 technical assumptions rarely hold in the modern world of today.
Government has to intervene in order to correct the inefficiencies that occur.

According to Richard Musgrave, the government should intervene in the 3 aspects as

set out below:
• the distribution branch, where the State has to pursue end-results and process
equity;
• the allocation branch, in charge of correcting for any inefficiencies that arise;
• the stabilization branch, in charge of pursuing macroeconomic policy goals
such as full employment and price stability.

Under the allocation branch, the goods and services produced reflect the consumers’
tastes and preferences. Moreover, only the more efficient firms survive in the long
run as all abnormal profits are eliminated.
The only possible exception where government might need to intervene might be
the establishment of a legal and judicial system to enforce contracts and define
private property rights.

Under the distribution branch, government has to intervene in order to regulate the
distribution of income. The government would achieve this objective through a policy
of tax and transfer program. The market takes the initial distribution of resources as
a given; it does not redistribute.

The allocation branch comes into play because the market and technical assumptions
underlying the well-functioning economy do not hold in practice. When they do not,
the economy is driven below its utility possibilities frontier and action by the
government is almost always required to bring the economy back to the frontier.

Many market transactions give rise to externalities, both harmful (e.g. pollution) and
beneficial (e.g. a minimal level of education in a democratic society) third party
effects. The example given was air pollution resulting from the production of paper.
Left to its own devices, the market selects a supply and demand equilibrium that
equates the marginal value of paper to consumers with the private marginal cost to
the firms of producing paper. The efficient equilibrium is the one that equates the
consumers’ marginal value of paper to the full social marginal cost of producing
paper, equal to the firms’ private marginal cost plus the sum of the marginal
damages to all parties affected by the pollution.

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A nonexclusive good, such as national defense or national security, has the property
that if anyone buys the good, everyone automatically consumes the full services of
the good whether they want to or not. These goods would lead to a free-rider
problem if they were marketed – everyone waits for one person to buy the good so
that no one buys it.
Thus the government has to provide nonexclusive goods.

Production is often characterized by substantial economies of scale or decreasing

costs at the level of the firm. This is called a natural monopoly, since a single
producer should supply the market to save on resource costs. The producer must
then be regulated or the government must take over the provision of the service to
ensure that it operates efficiently. Natural monopolies are characterized by high set
up costs and relatively low operating costs.

There are many important examples: the electric, water, and sewage public utilities;
recreational facilities such as parks and beaches; transportation, such as highways,
bridges, tunnels, and mass (rail) transit; TV and radio broadcasting and other forms
of telecommunications; and software, a truly global natural monopoly.

Private or asymmetric information, in which individuals or firms have information

about themselves that others, including the government, cannot know, or cannot
know without undertaking considerable effort and costs to find out. Private
information has three implications for governments.
a. It leads to many kinds of market failures that require government intervention.
Examples include: Consumer Protection Units that test and monitor products to
certify that the claims firms make about their products are true; and markets for
many kinds of insurance, such as unemployment insurance and medical insurance.

b. Private information strains the ideal of the government acting as an agent on

behalf of the people, since people often have an incentive to use their private
information to conceal important information from the government. Examples include
people not declaring some income under an income tax that they know is taxable, or
hiding income so that they become eligible for transfer programs that are not meant
for them.

c. Private information can be viewed as the ultimate source of all allocation activity,
because if people had perfect information they would use any and all methods to
move back to the frontier.

Purposes of a taxation system

The design of taxes is clearly part of a society’s pursuit of end-results equity because
the necessary redistributions to achieve equity are made through taxes and transfer
payments. Taxation has four main purposes or effects: Revenue, Redistribution,
Repricing, and Representation.

The main purpose is revenue: taxes raise money to spend on roads, schools and
hospitals, and on more indirect government functions like market regulation or legal
systems. This is the most widely known function.

A second is redistribution. Normally, this means transferring wealth from the richer
sections of society to poorer sections.

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 MBA (Finance & Investment) – Business Laws & Taxation

A third purpose of taxation is repricing. Taxes are levied to address externalities:

tobacco is taxed, for example, to discourage smoking, and many people advocate
policies such as implementing a carbon tax.

A fourth, consequential effect of taxation in its historical setting has been

representation. Several studies have shown that direct taxation (such as income
taxes) generates the greatest degree of accountability and better governance, while
indirect taxation tends to have smaller effects.

Funds provided by taxation have been used by states and their functional
equivalents throughout history to carry out many functions. Some of these include
• expenditures on war, the enforcement of law and public order,
• protection of property,
• economic infrastructure (roads, legal tender, enforcement of contracts, etc.),
• public works,
• social engineering, and
• the operation of government itself. Governments also use taxes to fund
welfare and public services. These services can include education systems,
health care systems, pensions for the elderly, unemployment benefits, and
public transportation. Energy, water and waste management systems are also
common public utilities.
• Colonial and modernizing states have also used cash taxes to draw or force
reluctant subsistence producers into cash economies.

Conclusion

Since markets are rarely competitive, it can be concluded that taxes are justified as
they fund activities that are necessary and beneficial to society. Additionally,
progressive taxation can be used to reduce economic inequality in a society.
According to this view, taxation in the modern world of today benefit the majority of
the population and social development.

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