THE ECONOMICS OF TAXATION

The Economics of Taxation 1 EDZ E.

Table of Contents
Page Table of Contents General Concept: Taxation Role of Taxation Effects of Taxation on Economic Growth References 1 2-9 9 -15 16 - 19 20

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General Concept

Taxation is defined as the bloodline of every government and has been at the heart of economy throughout the history. Major revenue of the government is sourced from taxation to carry its functions and to sustain during pressing times of financial and economic crisis. Taxes are compulsory levied by the government on income, expenditure or capital assets to raise revenue to support the indispensable and all the necessary expenses of the government.

In general, every tax has two parts, a base and a rate structure. The base of a tax is the measure or value upon which the tax is levied. Tax bases may be either stock measures or flow measures.

The rate structure of a tax determines the portion of the base that must be paid in tax. Indirect taxes are seen as regressive; the Direct

proportion of income paid in tax decreases as income rises.

taxes are progressive because the proportion of income paid in tax increases as income rises. With a progressive tax, the marginal rate of tax exceeds the average rate of tax. As a result, progressive taxes act to reduce inequalities in the distribution of income. The post-tax distribution of income will be less dispersed than the pre-tax

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distribution. With a proportional tax, the proportion of income paid in tax remains constant as income changes. In this situation, the marginal rate of tax will be equal to the average rate of tax. Any tax that does not vary with income is called a lump sum tax

By nature, power to tax is inherent in a sovereign estate so that the grant of which is not necessary but the exercise is provided for safeguards and limitations. This would mean that for the existence and survival of a government, it does not require delegation from the supreme law of the land, the Constitution. However, exercise of such power upon the inhabitants is subject to limitations to curtail the exercises in such a way as not to abuse and misuse the said power to the detriment of the majority and to the advantage of the selected few. To tax subject such as person, property or excise, there must be a valid law imposing the same. The validity of a tax measure

presupposes the fact that it has overcome the test and scrutiny against it. The legislative department duly passes these tax measures.

Under Philippine tax system, Taxation is administered through the Bureau of Internal Revenue (BIR), which comes under the Department of Finance. The chief executive of the Bureau of Internal Revenue is the Commissioner who has exclusive and original

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jurisdiction to interpret the provisions of the code and other tax laws. The commissioner also has the powers to decide disputed

assessments, grant refunds of taxes, fees and other charges and penalties, modify payment of any internal revenue tax and abate or cancel a tax liability. Taxpayers can appeal decisions by the The laws

Commissioner directly to the Court of Tax Appeals.

governing taxation in the Philippines are contained within the National Internal Revenue Code. This code underwent substantial revision with passage of the Tax Reform Act of 1997.

Primary types of taxation

Individual Income Tax

Residents engaged in trade or businesses are taxed upon their net income (gross income less allowable deductions and personal exemptions) according to a schedule of rates ranging from 3% to 33%. The maximum rate will be reduced to 32% on January 1, 2000. Residency tests are used to determine resident alien status where the resident alien falls under the Individual Income Tax schedule of rates.

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Income Tax Table:

Not over P10,000 Over P10,000 but not over P30,000 Over P30,000 but not over P70,000 Over P70,000 but not over P140,000 Over P140,000 but not over P250,000 Over P250,000 but not over P500,000 Over P500,000 P50,000+30% of the excess over P250,000 P125,000+32% of the excess over P500,000 P22,500+25% of the excess over P140,000 P8,500+20% of the excess over P70,000 P2,500+15% of the excess over P30,000 P500+10% of the excess over P10,000 5%

Personal exemptions of the following amounts are allowed on the individual income tax return: Single Head of Family Married P 50,000 P 50,000 P 50,000

An additional 25,000 pesos exemption is given for each of the first four additional dependents.

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Passive income

Interest - A final tax of 20% is imposed on interest income. This tax is withheld at the source. Exceptions to this are:

i.

Interest income from a depositary bank with a Foreign Currency Deposit Unit is subject to a final tax rate of 7.5%.

ii.

Philippine long term investments of over five years are exempt from tax.

Dividends - A final tax of 10% is imposed on cash or property dividends from domestic corporations, joint stock companies, insurance or mutual funds, or regional operating headquarters of multinational corporations. The distributable net income, after

tax, of a partnership is subject to the same final tax as dividends.

Capital gains - The tax code imposes a final tax of 5% on net capital gains from the sale of stock in a domestic corporation up to 100,000 pesos. The tax is 10% for any income over 100,000 pesos. If the stock is stock exchange listed, a transfer tax of

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0.5% is also imposed. property. The capital gains tax is 6% on real

Fringe benefits - are housing, expense accounts, vehicles, household personnel, membership fees and educational fees are taxable under the fringe benefits tax and are payable by the employer, who is responsible for withholding it and remitting it to the government. The fringe benefits tax is 33% (going to 32% on January 1, 2000) of the grossed-up monetary value of the fringe benefits given to the employee.

Corporation tax Resident foreign corporations engaged in trade or business in the Philippines are taxed at the same rates as domestic corporations.

The corporation income tax rate is currently 30%.

The option to elect Optional Standard Deduction (OSD) is granted to individual taxpayers (self-employed and professionals) and just recently, to corporations (domestic and resident foreign

corporations) by virtue of RA 9504 the same law that increased the OSD rates of individuals.

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Value Added Tax (VAT) The VAT is equivalent to 12% of the gross selling price or gross value in money of goods or properties sold, bartered or exchanged. Any excise tax on these goods is also part of the gross selling price. In the case of imported goods, VAT is based on the total value of the goods as determined by the Bureau of Customs charges. plus customs duties, excise taxes and incidental

The VAT is an indirect tax.

While the obligation to

collect and remit rests with the seller, the cost of the tax may be passed on to the buyer, transferee or lessee of the goods, properties or services. A VAT registered entity may credit the VAT paid on purchases of other goods and services against the tax on its current period sales of goods or services. If the amount of input tax is greater than the amount of output tax, the excess may be credited against succeeding period output VAT.

Other taxes Percentage tax (primarily for non-VAT registered entities), Excise tax, Documentary stamp tax, Estate and donors (gift) tax, Local taxes on certain business such as Manufacturers, wholesalers, exporters and contractors are subject to graduated taxes on

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certain amounts of sales/gross receipts and percentage taxes at maximum rates ranging from .375% to .75% on the amounts not subject to graduated taxes, depending on the place where business is conducted and other varying local taxes such as community tax, real estate tax, etc.

Role of Taxation

The role of taxation in relation to economic development has to be viewed in the background of the function, which a taxation system performs. The primary function of a tax system is to raise revenue for the government for its public expenditure. This is to ensure that the government function is discharged adequately. Among other functions are: To reduce inequalities through a policy of redistribution of income and wealth, For social purposes such as discouraging certain activities which are considered undesirable, To ensure economic goals through the ability of the taxation system to influence the allocation of resources which includes transferring resources from the private sector to the

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government to finance public investment or the direction of private investment into desired channels through such

measures as regulation of tax rate and the grant of tax incentives to attract foreign direct investment into the country, To increase the level of savings and capital formation in the private sector To protect local industries from foreign competition through the use of import duties and to help the countrys international balance of payments

Tax system may have numerous objectives, such as the following: To keep the overall tax burden as low as possible To reduce tax rates on income to sharpen incentives to work and create wealth in the economy To maintain a broad tax base by having a range of taxes that helps to keep other tax rates low To shift the balance of taxation away from taxes on income towards taxes on spending To ensure taxes are applied equally and fairly to everyone To use taxes to make markets work better including the use of environmental taxes to make both consumers and producers aware of external costs

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However, there is much disagreement over what constitutes a fair tax system and this proves to be one of the criteria for evaluating the economy. The benefits-received principle contends that people

should bear tax burdens in proportion to the benefits that they receive from government expenditures, while the ability-to-pay principle contends that people should bear tax burdens in line with their ability to pay. If ability-to-pay principle is the basis for the distribution of tax burdens, the principles of horizontal and vertical equity is applied. Horizontal equity holds that those with equal ability to pay should bear equal tax burden, while vertical equity holds that those with greater ability to pay should pay more. But there are conundrums to these

principles, how should ability to pay be measured and how much should one contribute more if he has greater ability to pay?

There are three leading candidates to consider the best tax base, namely: (1) income, (2) consumption, and (3) wealth.

Income refers to an economic income. It is the value of what you consume plus any change in the value of what you own. This includes all money receipts, whether from employment, interest on savings,

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dividends, profits, or transfers from the government and the value of benefits received not in the form of money such as medical benefits, retirement contributions, paid country club memberships, and changes in asset values whether they are realized or not.

Economic Income = Consumption + Change in Net Worth

Consumption refers the total value of goods and services that a household consumes in a given period.

Wealth or Net Worth refers to the value of all the goods and services you own after your liabilities are subtracted

Net Worth = Assets Liabilities

In conventional wisdom among economists, they held that income was the best measure of ability to pay taxes but those who believe that consumption is a better measure have challenged this assumption and some still argue that the real power to command resources comes from accumulated wealth, but of course, when income is already taxed, a wealth tax in substance is tax the same.

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However, in the modern days, this system of tax is still on debate and every country has a system of taxation that taxes all three bases.

Based on the principle of tax analysis, the burden of a tax is ultimately borne by individuals or households. This refers to the

incidence of tax. This means that taxes paid by a firm ultimately fall on customer, owner or workers. This is a result of behavioral changes and market adjustments. Tax Shifting occurs when individuals or

households can shift their behavior and do something to avoid paying a tax. When labor supply is more elastic, firms bear the bulk of a tax imposed on labor, and on the other hand, when labor supply is inelastic, workers bear the bulk of the tax burden.

When taxes distort economic conditions, they inflict burdens on society that exceeds the revenue collected by the government. This is called the excess burden of the tax, also known as deadweight losses. The general principle that comes into view from the analysis of excess burden is the principle of neutrality. This means that all else equal, taxes that are neutral with respect to economic decisions is preferred to one that distorts economic decisions. The more elastic the demand curve, the greater the distortion caused by any given tax rate. Taxes change behavior and such change in behavior can affect supply and

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demand in markets, which case prices to change.

When prices

changes, either in input and output markets, some people may be made better off and some would get worse. However, a distorting tax is sometimes desirable when other distortions already exist in the economy. This refers to the principle of second best. A tax that

distorts an economic decision does not always imply that such a tax imposes an excess burden but may actually improved economic welfare when other taxes are present that already distort decisions.

Thus, a government should design and implement an equitable taxation regime. It should consider the following major aspects: a) Adequacy taxes should be justifiable enough to generate revenue required for provision of essential public b) Broad Basing taxes should be widely spread to the population, or sectors of economy, to minimize the individual tax burden c) Compatibility taxes should be coordinated to ensure tax neutrality and good d) Convenience taxes should be enforced in a manner that encourages and facilitates voluntary e) Earmarking tax revenue from a specific source should be dedicated to a specific purpose only when there is a direct cost-

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and-benefit link between the tax source and the expenditure, such as use of motor fuel tax for road maintenance f) Efficiency tax collection efforts should not cost an excessive percentage of tax revenues g) Equity taxes should be equally burden by individuals or entities in similar economic circumstances h) Neutrality taxes should not favor any one group or sector over another, and should not be designed to interfere-with or influence individual decision-making i) Predictability collection of taxes should reinforce their certainty and regularity j) Restricted exemptions tax exemptions must only be for specific purpose such as to encourage investment and for a limited period k) Simplicity tax assessment and determination should be easy to comprehend by an average tax payer

The concept that taxes affects market behavior would lead the government to assess and analyze for optimal taxation system. By

knowing how people will respond to taxes would allow our legislative government body to design a system that would minimize the overall excess burden.

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Effect of Taxation on Economic Growth

Some claim that a reduction in the tax rate will lead to increase in economic growth and in contrast some would say that if taxes would be reduce, almost all the benefits would go to the rich, as they are the ones who pay the most taxes. Government tax revenue does not

necessarily increase as the tax rate increases.

If we are going to assume in extreme case if there are no taxes, then the government does not earn any income from taxation and citizens do not spend any time worrying about how to avoid taxes. This would make them highly productive since they take home all what they earn. In contrary, productivity declines as the tax rate increases as they tend to choose to work less. In another point of view,

considering that the following are the necessary things a government must provide: 1. Army 2. Police Force 3. Court system

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Without these three functions, citizens will not be protected against foreign invaders, domestic criminals and crimes & disputes will not be legally settled. People would spend a lot more time trying to steal what they need and a lot less time trying to produce what they need, as stealing something is often easier than producing it yourself. And this leads to a reduction in economic growth. A police force, which protects the basic human rights of citizens, is absolutely necessary to ensure economic growth. A court system also promotes economic

growth. A large portion of economic activity depends on the use likewise of contracts. If there's no way to enforce a contract, then there is no way to ensure that the laborer for example will end up getting compensated for the labor.

Having these basic three functions of the government, it provides a large economic benefit to a society. However it is expensive though for a government to provide such services, so they have to collect money from the citizens of the country to finance such programs through taxation. With this, we observe that taxation

enables the government to these services that will have a much higher level of economic growth than a society with no taxation.

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In this case, we can say that an increase in taxes can lead to larger economic growth, if it is used to pay for one of these services. However, its not necessarily the case that giving more of these services will lead to greater economic activity than none at all. If for example an armed forces are already large enough to deter any potential foreign invaders, then any additional military spending drags down economic growth. It is now determined that the higher taxes

can lead to higher economic growth if the taxes are efficiently spent.

There are also other government programs, which can bring a net benefit to the economy when fully paid for by taxes. For instance, if the roads and public highways are constructed well, people and goods can freely travel and transport. Taxes, which lead to

improvements in infrastructures, can lead to a higher economic growth. However, this depends on the usefulness on the

infrastructure being created. A country needs infrastructure to have a high level of economic activity. However, too much spending or spending on the wrong infrastructure can be wasteful and slow economic growth. Moreover, an improvement to safety in the water supply in a rural area might be worth the benefit if it leads to reduced illness and suffering for the users of the system. In most western democracy countries, the majority of government spending goes

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towards social programs, mainly health care and education. By giving health care coverage especially to the poor, being in good health may improve their productivity, likewise, people with more education tend to be more productive than people with less education and this could lead to economic growth.

A reduction in taxes does not necessarily help or damage an economy. The government must consider what the revenue from those taxes is being spent on before determining the effect of the reduction in taxes will have on the economy.

While there is often no direct perceptible correlation between tax policy and actual development performance due to the extensiveness of a variety of variables, the links between fiscal policy and economic growth are there. Commonly this is mostly indirect, operating through the capital, labor and product markets.

Further, another significant reason why taxation is essential in getting macro economic policies right is that alternative ways of financing government expenditures such as money creation,

mandating larger required reserves, domestic borrowing and foreign loans can have very harmful effects on the economy.

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References:
Principle of Economics by Karl E. Case, Ray Fair, Sharon Oster 9th Edition www.bir.gov.ph http://tutor2u.net/revision_notes_economics_gcse.asp http://mises.org/daily/ http://mitpress.mit.edu/catalog/browse/type.asp?ttype=2 The Economics of Taxation by Henry Aaron & Michael Boskin http://economics.about.com/od/incometaxestaxcuts/Income_Taxes_Tax_Cuts.htm The Economics of Taxation: Principles, Policy by Simon James, Prof Christopher Nobes http://www.nationsencyclopedia.com/ http://economics.about.com/cs/taxpolicy/a/taxing_growth_2.htm