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LM1 - Taxes Should Be Sufficient 1
LM1 - Taxes Should Be Sufficient 1
Tax policy can be defined as a government’s attitude, objectives, and actions with respect to its
tax system. It reflects the normative standards that the government deems most important.
Business managers and their tax advisers share a keen interest in taxpolicy. They know that
many complex rules in the Internal Revenue Code have an underlying policy rationale. If they
can understand this rationale, the rule itself is easier to interpret and apply. Moreover, business
managers know that today’s policy issues shape tomorrow’s tax environment. By paying close
attention to the current policy debate, managers can anticipate developments that might affect
their firm’s long-term strategies. Their familiarity with policy issues helps them assess the
probability of changes in the tax law and develop contingent strategies to deal with such
changes.
A tax is sufficient if it generates enough funds to pay for the public goods and services
provided by the government. After all, the reason that governments tax their citizens in the first
place is to raise revenues needed for specific purposes. If a tax (or combination of taxes) is
sufficient, a government can balance its budget. Tax revenues equal government spending, and
the government has no need to raise additional funds.
What is the consequence of an insufficient tax system? The government must make up its
revenue shortfall (the excess of current spending over tax receipts) from some other source:
a. Governments may own assets or property rights that they can lease or sell to raise
money.
b. Another option is for governments to borrow money to finance their operating deficits. By
selling both short-term instruments (such as Treasury bills) and long-term bonds,
governments with insufficient tax systems can make ends meet. Debt financing isn’t a
permanent solution to an insufficient tax system. Like other debtors, governments must
pay interest on borrowed funds. As the public debt increases, so does the annual
interest burden. At some point, a government may find itself in the untenable position of
borrowing new money not to provide more public goods and services but merely to pay
the interest on existing debt. In a worst-case scenario, a government may be forced to
default on its debt obligations, damaging its credibility and creating havoc in its capital
markets. Yet politicians continue to tell their constituencies that taxes are too high, and
few people seem inclined to disagree. But the arithmetic is inescapable. If we want to
pay less tax and at the same time curb the growth of the national debt, the federal
government must cut spending. If we want our government to maintain its level of
spending without incurring additional debt, we should be prepared to pay the necessary
federal tax.
In the Fairview example, the increase in the tax rate caused a decrease in the tax base.
Because Fairview failed to anticipate this effect, it overestimated the incremental revenue from
the rate increase.
Dynamic Forecasts
Dynamic forecasts - projections, which assume a correlation between rate and base. If a
jurisdiction can predict the extent to which a change in tax rates will affect the tax base, it can
incorporate the effect into its revenue projections.The accuracy of dynamic forecasts depends
on the accuracy of the assumptions about the correlation.
In a complex economic environment, a change in tax rates may be only one of many factors
contributing to an expansion or contraction of the tax base. Economists may be unable to isolate
the effect of the rate change or to test their assumptions empirically. Consequently,
governments have generally relied on static forecasting to estimate the revenues gained or lost
because of a tax rate change.