Idea of Taxation

Written by: Ronak Pol
Published: December 1oth, 2016

Paying your fair share of tax has often been politicised as your fiscal responsibility towards the nation. Still, taxpayers around the world go to great lengths to cook their books such that huge sums of money can be offloaded without paying the appropriate tax. In today’s article, we explore the concept of taxation and understand how free riders can cause a disincentive to pay tax.

Why pay tax?

Taxation as a concept dates back centuries even before the Greek and the Roman empires where the tax was collected to fund the military and other public expenditure. Over the years the idea behind taxation has remained more or less similar and with increased monetary sophistication, taxation rules have also become more complex.

But the basic idea of using the tax collected to carry out public expenditure remains the same. A novice at this point would argue about why can’t the government just print the money it needs to spend. But the complications of seignorage ( difference between the cost of printing money and face value of money ) and the way it affects our economy keeps the idea out of the purview of today’s discussion. But simply put, printing more money is likely to cause a devaluation of our currency and lead to inflation. Hence it is not really a smart idea to print money and carry out public spending.

Taxation, Public goods and Free rider problem?

Public goods can be defined as “Commodities or services that are non-rivalrous and non-excludable”. The nature of government expenditure makes the services and commodities offered by them a public good for eg. Roads, Bridges, Security services in terms of Military and local governance.

The nature of these commodities leads to free rider problem as it is impossible to stop an individual who does not pay for the services from using them. For example, if someone does not pay the tax you can not withdraw the military protection offered to him by the state, hence there is no incentive for anyone to pay the tax. Considering there is a natural incentive to free ride, a system without rules would collapse. Hence we have introduced laws that force individuals to pay a tax and solve the free rider problem.

How much Tax?

Not everyone pays the same amount of direct tax or even the same proportion of tax, the amount of tax you pay is generally determined by the amount you earn. This is because for individuals who earn more have the ability to pay more tax without critically affecting their standard of living or purchase decisions. On the other hand, if people from the lower strata of the society are asked to pay the same amount of tax, chances are their lives will be altered more critically and possibly for the worse. This structure of the tax system creates natural free riders who do not pay for the services but are getting all the benefits that a person who pays for the service gets.

This places a disproportionate amount of burden on people who are supposed to pay tax. Individuals who pay tax, pay for services that are enjoyed by everyone in the nation. Including for people who do not pay any tax and are rather on government support schemes. Understanding the disincentive this problem creates for the people who are eligible to pay the tax can help us understand why some people refuse to pay their fair share of taxation. And a lot of it also boils down to how do you estimate the fair share of someone’s tax, how sensitive you are towards the people who do not pay tax and how well are the taxation laws implemented.

Conclusion.

The idea behind this article was the provide a brief window into how taxation, public goods and free rider problems are interconnected and how reducing the free riders might help improve the incentive for everyone to pay their fair share of tax.

In the next article, we will explore some of the ways to evade taxation, specifically the idea of tax heavens and how they contribute to tax evasion in any country.

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One thought on “Idea of Taxation

  1. Intelligent Investor says:

    I wouldn’t say free riders are the only problem.

    Its when most people reach the first threshold of income that makes them enter the first tax bracket, which is when one earns upwards of 250000 per annum. This is to say that it is theoretically better to earn 249999 because you dont pay into the system and you enjoy a large disposable income. But when you earn 250001, the story is very different.

    Those people who are very close to that figure are those earning around 21000 rupees. So earlier in the past, they used to accept some portion of their salary in black money. But now that demonetisation and remonetisation has taken place, everyone will be expected to adhere to an archaic law which threatens to hurt the person with lower wages.

    My personal view is that they should make the tax bracket start higher… Allow people to earn upto 720000 per annum without paying tax because once someone is already earning enough for themselves, they can then begin to do tax planning rather than avoid tax altogether.

    Another radical option is to get rid of income tax altogether and have a standardised banking transaction tax which taxes the number of transactions rather than the income. Although it may seem fair at first, there are many unfortunate ones like high frequency traders and money managers who may get hurt by the move.

    Like

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