International Taxation

Chapter 1: Basics of Taxation

Semester 2, Jan. – March
Rennes School of Business
Instructor: Akanksha JALAN
Session contents:

• The meaning and nature of taxes

• Purpose of taxes

• Principles of a good tax system

• Elements of taxes

• What is a tax return?

• Other useful terms in taxation

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What is a Tax?
• James (1998), in his Dictionary of Taxation defines a tax as ‘A compulsory levy
made by public authorities for which nothing is received directly in return’.
• Characteristics of a tax:
• Compulsory
• Made by public authorities
• Nothing received directly by the taxpayer in return
• Only indirect benefits such as general improvement in infrastructure, economic stability etc.
may be expected in return.
• Failure to pay may result in fines and penalties on the non-paying taxpayer.

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Why do Governments tax?
• To ensure the smooth running of the economy, every Government
must undertake public spending.
• Common examples of public spending include the building of
hospitals, health care, grants and subsidies to businesses, defense
and security etc.
• The ability of the State to spend directly depends upon its revenues
or simply, incomes and inflows.
• The most important source of State revenues are taxes or levies.
• These are imposed by the State and collected by a government
agency such as the Internal Revenue Service (IRS) in the US and
Her Majesty’s Revenue and Customs (HMRC) in the UK.

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Main purposes of taxation – the 4 R’s
Revenue: To raise revenues for the State to be used in public
spending and welfare.

Redistribution: To assist in creating greater equality in income

among the masses by transferring wealth from the richer to poorer
sections of society.

Repricing: To discourage certain types of consumption patterns or

behavior. For example, taxes on alcohol and cigarettes deter their
use, carbon taxes discourage the use of carbon-based fuels.

Representation: To create civic consciousness and need for greater

accountability by taxpayers from the Governments to whom they
pay taxes.

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What does a ‘good’ tax system look like?

• These are the characteristics that a good system of taxation

must possess.

• As early as in the 18th century, Adam Smith in his book

‘The Wealth of Nations’ listed four principles that he called
the ‘canons of taxation’.

• He believed that a good system of taxation should balance

the interests of the taxpayer and the tax authorities that
impose and collect the taxes.
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The 4 Canons of Taxation
Equity: The tax should be socially and morally fair in the sense that
each person pays according to his or her own ability. This ensures a
more equal distribution of income and wealth in society.

Certainty: The taxpayer should know well, the nature, purpose,

amount and due date of the tax payment.

Convenience: The time and manner of tax payment should be easy

and convenient to the taxpayer, to avoid incentives to avoid taxes.

Efficiency: The Government’s administrative costs of collecting

taxes should be minimized to ensure maximum collection for public
spending.

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The 3 elements of Taxes

Any tax, of whatever nature, contains three essential elements:

1. The tax base, i.e. the subject of the tax or the ‘thing’ on which the
tax is being levied;

2. The rate of tax that must be applied to the base to calculate tax
liability;

3. A taxpayer, i.e. someone who shall pay the tax.

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Element 1: The tax base

Generally 4 main bases

3. Income and profit

1. Consumption taxes 2. Wealth Taxes 4. Head (or poll) taxes
taxes

Taxes on what we spend/ Taxes on what we earn Taxes on us as human

Taxes on what we own.
our expenditure. during a period. beings for ‘existing’.

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Element 2: The tax rate
1. Proportionate or Flat rate
For every extra unit in the
tax base, the rate applied
remains constant.
Eg. The corporate tax rate in
the US (35%)
Three common types
2. Progressive rate 3. Regressive rate
The rate increases
proportionately with the size
of the tax base. Very rare. In this case, the
tax rate falls as the tax base
Eg. Personal income tax in increases.
France based on different
slabs of income.
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Types of tax rates

Theoretically speaking, there can be two types of tax rates – effective

and marginal.
1. Effective (or average) tax rate is the average rate at which a tax has been
paid. It can be calculated by dividing the total tax paid by the amount of tax
base to which it is applied.

2. Marginal tax rate is the rate of tax that must be paid on every additional
unit of the tax base.

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Average vs. Marginal tax rate - Example
Mr. Richie, a US resident, has a taxable income of $175,000 in 2019. The tax rates that apply to him are the

following:

Taxable income Tax rate

$0 - $50,000 5%
$50,000 - $100,000 10%
Above $100,000 15%

Required:

For Mr. Richie, calculate the effective and marginal tax rate for the year 2019.

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Solution (1)
Step 1: Calculation of tax liability:
• For this, we require only two things – the tax rate(s) and the tax base (or simply
taxable income in this case).
• Since we are working with a tax slab (different rates for different levels of
income), we will have to calculate the tax liability in a series of steps.
Taxable income Tax Tax calculation Tax liability
rate (amount in $)
$0 - $50,000 5% 50,000 X 5% $2,500
$50,000 - $100,000 10% 50,000 X 10% $5,000
Above $100,000 15% (175,000 – 100,000) X 15% $11,250
Total tax liability $18,750

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Solution (2)
Step 2: Calculating effective and marginal tax rates
Total tax liability
1. Average/ Effective tax rate =
Taxable income
18,750
= 175,000 = 10.71%

2. Marginal tax rate

• This is simply the rate at which Mr. Richie must pay taxes on an extra $ of income earned.
• Unfortunately (or may be not!), he is in the highest tax bracket of 15%. So any additional dollar earned will
also be taxed at 15%.
• So, Marginal tax rate in this case = 15%
Note: In this case, you will find that the effective tax rate is lower than the marginal rate. This is a common
feature of progressive taxes like the income tax in this case.

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Element 3: The taxpayer
• Any person (living or otherwise) that may be required to file and pay its taxes in
its home country is the taxpayer, also known as a taxable entity.

• The taxable entity could be an individual, a partnership firm, a sole-proprietorship,

a public or private company, a Limited Liability Company (LLP) among others.

• The rules for determining taxable income filing of tax returns and payment of
taxes are typically different for each of these categories, depending upon the
country concerned.

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Impact vs. Incidence of a tax
• The impact of the tax falls on the person who is legally liable to pay the tax on
the day it is due.

• The incidence of the tax falls on the person who finally bears the tax.

• This brings about an important discussion about Direct and Indirect taxes
• For Direct taxes: The incidence and impact fall on the same person since these taxes cannot be passed
on to someone else.
• For Indirect taxes: The incidence and impact fall on different people, i.e. the person who pays the tax

passes it on to someone else, usually the consumer.

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 Direct vs. Indirect Taxes
Basis of distinction Direct taxes Indirect taxes
1. Basis of imposition Imposed on the income and wealth of the Imposed on the expenditure/ consumption of
taxpaper, i.e. on receipts. the taxpayer out of his earnings.
2. Amount of tax Is clearly known to the taxpayer. Typically not known to the taxpayer since
taxes are included in the prices of goods and
services.
3. Pinch of the tax Sometimes, these can be as high as 30%, Since the amount is hidden and usually
causing a severe economic pinch to the unknown to the taxpayer, they do not really
taxpayer. pinch him.
4. Who pays the State (impact) The taxpayer directly. The seller/ supplier of goods and services

5. Who bears the burden of the The taxpayer himself. The ultimate consumer of the goods and
tax (incidence) services since the seller passes on the tax
burden to the consumer by raising the price
of his product.
6. Examples Wealth tax, Income tax Sales Tax, Value Added Tax, Excise duty
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What is a tax return
• It is the document to be filed by a taxable entity to the
concerned tax authority at the end of each specified
period for the determination of taxes to be paid.
• It typically contains:
• The name, address and tax identification number of
the taxpayer,
• The financial period to which the return relates (a
year, quarter etc.),
• Total incomes and expenses for the period,
• Computation of the amount of taxable income and
taxes to be paid/ refunded.

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The 3 main sections of a tax return
Incomes: This lists the total amount of income earned during
the period concerned from all sources – wages and salaries for
individuals, profits for businesses etc.

Deductions: These are amounts that the tax law permits to be reduced
from total income in (1) above, to reduce tax liability. For example,
expenses of running the business are deductible expenses for
calculating the taxable income of a business entity. Similarly,
investment in specific retirement plans for individuals is deductible.

Tax credits: These further reduce tax liability by subtracting

items such as expenses on the care of dependent children and
seniors, pensions etc. to calculate taxable income. 19
Some other useful
terms
Deadweight costs of taxation
• Taxes are believed to reduce economic efficiency by introducing a
‘deadweight loss’.

• This simply means the following: when a new tax is introduced, the final
price received by the seller is lower than before. This may discourage him
from producing and selling, which means fewer goods and services in the
market.

• The extent of the deadweight loss caused by a tax depends upon the
elasticity of the demand and supply of a particular product or service.

• Most taxes, including income tax and sales tax have very high deadweight
costs since they change the incentives to produce and sell.

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Pigovian taxes
• The name of this category of taxes comes after economist Arthur Pigou,
who proposed this idea.

• The existence of a tax can increase economic efficiency in some cases,

particularly in terms of discouraging certain harmful consumption
patterns.

• For instance, taxes on alcohol, tobacco and cigarettes.

• Another example is taxes on carbon emissions and the use of polluting

(and scarce) fossil fuels such as petrol.

• By doing so, not only does the State raise revenues, overall welfare of
the people is maximized by discouraging harmful consumption.
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Costs of compliance
• In every country, the State must manage the administrative machinery
for collecting taxes and therefore, incur costs of collection.
• Inspite of this, a good part of these tax-related costs must be borne by
individual and business taxpayers too. These are called compliance
costs since they represent the costs of complying with the tax laws of
the State.
• For instance, the cost of getting the tax books audited, the cost of
filing returns, consulting a tax lawyer etc.
• More complex tax systems tend to have higher costs of compliance
for the taxpayers.
• This acts as a very strong incentive for taxpayers to avoid/ evade
payment of taxes.

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Thank you!