Role of taxation in development strategy Tax system: The Role of taxation and fiscal policy in the development strategy

has to be viewed in the background of the functions which a taxation system performs. Its main functions in relation to economic development are as follows. 01. Functions of Taxation in Relation to Economic Development 01. The primary function of a tax system is to raise revenue for the government for its public expenditure. So the first goal in the development strategy as regards taxation policy is to ensure that this function is discharged adequately. 02. To reduce inequalities through a policy of redistribution of income and wealth. Higher rates of income taxes, capital transfer taxes and wealth taxes are some means adopted for achieving these ends. 03. For social proposes such as discouraging certain activities which are considered undesirable. The excise taxes on liquor and tobacco, the special excise duties on luxury goods, betting and Gaming Levy are examples of such taxes, which apart from being lucrative revenue sources have also goals. 04. To ensure economic goals through the ability of the taxation system to influence the allocation of resources. This includes. a) Transferring resources from the private sector to the government to finance the public investment program; b) The direction of private investment into desired channels through such measures as regulation of tax rates and the grant of tax incentives etc. This includes investment incentives to attract foreign direct investment (FDI) into the country; c) Influencing relative factor prices for enhanced use of labor and economizing the use of capital and foreign exchange. 05. To increase the level of savings and capital formation in the private sector partly for borrowing by the government and partly for enhancing investment resources within the private sector for economic development. 06. To protect local industries from foreign competition through the use of import duties, turnover taxes/VAT and excises. This has the effect of transferring a certain amount of demand from imported goods to domestically produced goods. 07. To stabilize national income by using taxation as an instrument of demand management. Taxation reduces the effect of the multiplier and so can be used to dampen cyclical fluctuations on the economy.

02. Principles of taxation A tax system is based on certain basic principles. They are equity, progressively, simplicity and efficiency. Equity - The equity principle implies that taxation must be imposed in accordance with the ability to pay principle. Equity has two dimensions, horizontal equity and vertical equity. Progressively - A tax system can either be progressive or regressive. Direct taxes for example, income tax is generally progressive in character with an exemption tax free threshold for the smaller income receivers and a graduated rate schedule. Simplicity - A taxation system must be as simple as possible with a few taxes and uncomplicated legislation. However often tax systems are complex with a large number of taxes and levies imposed for revenue considerations and tax legislation is necessarily complex in character. Efficiency - Finally a tax system must be efficient. No amount of sound fiscal policy is effective if the tax administration system is inefficient or corrupt. 03. Tax factors that affect development and growth Taxes affect growth in two ways. First, by influencing the aggregate supply of the main factors of production by raising or lowering their net (after tax) returns; and second, by influencing the efficiency of resource utilization factor (total productivity). Some of the main factors in this process are given below. 01. Tax revenue ratio to GDP: Since an adequate volume of government revenue is essential for public expenditure and economic growth, the ratio of tax revenue to GDP has been used regularly to measure and judge the success of a country's fiscal management. The main reasons for the decline include * Unplanned and ad hoc tax holidays and incentives. * Narrow tax base and inadequate coverage. * Lack of elasticity and buoyancy in the tax system. * Periodic tax amnesties. * Administrative weaknesses.

2. Tax rates, saving and capital formation: It is difficult to establish a direct and precise statistical correlation between tax rates and private capital formation due to many factors and the time lag, changes in the tax base and other externalities determining investment. Nevertheless historical and statistical trends tend to suggest that savings and private capital formation have been sensitive to effective tax incidence. 3. Tax elasticity and buoyancy in development: A principal fiscal in any development strategy is to increase the elasticity and buoyancy of the revenue systems. Elasticity reflects the built-in responsiveness of tax revenue to movements in national income or GDP. Buoyancy reflects the total response of tax revenue to changes in national income or GDP including the effects of discretionary changes in tax policies over time. 4. Taxation and demand management: Taxation has been often used in many countries as a tool in countering inflationary and deflationary pressures on the economy. Such pressures affect development through a lack of external balances and/or in a spiral of changing prices and employment. In mitigating the effects of cyclical pressures monetary policy, through traditionally more effective is often limited by the structural nature of the economy and therefore tax policy assumes major importance. 5. Tax incentives in the development strategy: Tax and investment incentives have in recent times become a favourite tool in development strategy both for domestic investors and for attracting foreign direct investment (FDI). The rationale for their use is that they constitute an important, if not a major, element in determining investment behavior. Incentives increase the net of tax rates of returns and thereby reduce the need for large initial capital investment and also reduce risk. The availability of incentives tends to make otherwise unpromising and risky ventures more profitable. They are also valuable as an indirect stimulus to investment because they publicize and enhance the country's investment climate. The role of tax incentives in determining investment behavior has however been controversial. According to current studies, incentives by themselves do not play a major role in determining investment vis-a-vis other factors such as economic and political stability, infrastructure facilities, cheap and easy credit, access to markets, reliable and skilled labour force. Nevertheless tax incentives schemes are in place in a large number of developing countries and form a significant part of the development strategy being adopted. 6. Taxation, black money and the informal economy: A sound development strategy seeks to reduce the size of the informal economy and bring into the open economic resources that lie untapped in the form of black money.

Apart from such mechanisms as tax and foreign exchange amnesties and demonetization, taxation has been used as a tool to tap the resources inherent in these areas. Large scale tax evasion and the existence of a large black economy while resulting in loss of revenue to the state, tends to reduce the built-in elasticity of a fiscal system and to the extent that the tax evaded income is spent on goods and services, help to generate inflationary pressures and raise the prices of real property. 7. Customs duties in the development strategy: Import and export duties have been traditionally used not only as a means of deriving substantial government revenue but also as a tool in the development strategy. Export duties have been used as an instrument of siphoning off excess demand in times of inflation and stimulating them in times of depression. In the use of export duties however, there is clearly a conflict between the objectives of revenue and export development. 8. Role of the tax administration in development: Finally, development policy requires the existence and functioning of a sound and effective tax administrative machinery. No amount of development planning would have the intended effect if the required stability and level of a administrative resources are not invested in their implementation. 9. Summary: The above sections dealt with some of the main components in the relationship between taxation and development. While there is often no direct perceptively correlation between tax policy and actual development performance due to the prevalence of a variety of variables, the links between fiscal policy and economic growth are there. Often this is mostly indirect, operating through the capital, labor and product markets. Finally, another important reason why taxation is essential in getting macro economic policies right is that alternative ways of financing government expenditure such as money creation, mandating larger required reserves, domestic borrowing and foreign loans can have very harmful effects on the economy.

There are three major ways that government influences the economy:

Taxation, to raise revenue Expenditure, to create "public goods" such as roads, schools or police protection -- or to provide support to needy people via transfer payments Regulation, to protect health, safety or the environment.

Government's role in the economy is always the biggest and most contentious part of political debate. The sides of the debate about government's role are generally termed the "Left Wing" and the "Right Wing". The Right Wing's demands for greater freedom and less governmental interference and control are countered by the Left Wing's calls for more equal distribution of wealth and better protection of health and the environment. The debate goes on, and on, and on, through the muddled ebb and flow of the modern mixed economy. One thing we know for sure about taxes, though, is that nobody wants to pay them. Taxes on goods increase their price. Taxes on wages decrease the amount that consumers are able to spend. Taxes on profits lower the funds businesses have available for new investment. This pervasive fact has led to the modern strategy of "broad-based" taxation. The general logic is that since taxation is painful to everybody, government will spread the tax burden out over as many different sources as it possibly can. How do we decide whether taxes are fair? Two general criteria are used: the principle of ability to pay, and the principle of benefits received. The benefits-received principle asks for a higher tax payment from people who enjoy more benefits from government; and example would be the charging of a higher property tax to people living closer to good schools and public transportation facilities. Taxes are called "progressive" when they place a greater burden on people with higher income. They are called "regressive" when the place a greater burden on the poor. Thus, an income tax that charges higher rates to higher-income people is a progressive tax, while a sales tax, which charges the same tax rate regardless of the buyer's income level, is a regressive tax. Since regressive taxes seem unfair, we might be led to wonder why they are so popular! One reason is that a tax that levies a small amount on the purchase of very common goods is an easy way to raise a lot of revenue without people noticing it as much. The complexity of tax policy in modern society is almost beyond imagining. You might think, for example, that a by these criteria a property tax would be a much better tax than a sales tax. Property values are a direct result, after all, of benefits received by the users of nearby public services -- and, people with a greater ability to pay generally own higher-priced property. Sales taxes, meanwhile, place a greater burden on the poor, and slow down the overall economy by adding to prices? Yet, odd as it may seem, many states have been deciding in recent years to rely more heavily on sales taxes, and relieve property taxes!

Why is that? Because tax policies are established by elected legislators who are subject to political pressures. The payers of sales taxes tend to be a large, diverse, unorganized group. Property owners, on the other hand, tend to be a smaller, more organized group, each of whom has a higher personal stake in the issue. These facts of political life create an all-but-unstoppable tendency for the tax system to become more complicated all the time. Since taxation burdens everyone, then a little bit of relief from taxation for a particular locale or industry can be used as a political favor. Such political horse-trading goes on all the time, and its legacy is the income tax system. The full text of federal tax regulations, called the "Tax Code" is many volumes long and gets bigger every year. An entire industry is devoted to helping bewildered citizens and businesses figure out how much tax they must pay. Many people claim that the Federal income tax is illegal for various reasons. If, when they fill out their annual tax returns, citizens fail to declare taxable income, they can be prosecuted for tax evasion. (This is actually the means by which legendary racketeer Al Capone and other organized crime figures were caught and sent to jail.) This creates an interesting legal problem. The Fifth Amendment to the US Constitution protects citizens from being compelled to provide self-incriminating evidence in any criminal prosecution. Yet, when people are convicted of tax evasion, the tax return that they were compelled to file is used as evidence against them. This does appear to violate the Fifth Amendment right against self-incrimination. However, the US Supreme Court has ruled that not to be the case. As early as 1927, the Court has upheld convictions of citizens for failing to file a tax return. The issue of taxation seems to pose yet another dilemma to the "dismal science" of economics. The political nature of tax policy seems to lead us to make unfair and inefficient choices in how we fund government services. Yet if government does not provide these services, the market will only provide them in ways that are grossly unfair and inefficient! So far, we have just managed to muddle through, somehow, adding new reams to the tax code every year. Do we have any other choice?