THE BASIC THEORY OF TAXATION

Taxation and the Allocation of Resources

Tax Incidence : Who Bears the Tax Burden? (The
Statutory and Economic Incidence of a Tax)
Tax Policy Analysis
Central Government versus Sub-National
Governments Tax Systems
Tax on Personal Incomes
Income Tax and Household Behavior
Tax on Business Income
Budget Surpluses and Deficits
Reforming the tax Systems

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Lanjutan..
Provincial and local Taxes
Problems faced by multiple tax authorities
Establishing the Right to Tax
Allocating the Tax Base
The Efficiency of Multijurisdictional Taxes
Tax Exporting (the burden of a tax is shifted to someone
outside the jurisdiction)
Tax Competition (occurs when a local govt sets its tax rate
marginally below the tax rates prevailing in other localities
in order to attract the tax base into its jurisdiction).
Provincial and Local tax Structure
A Case Point : Land and Building Tax and Acquisition
Duty of Right on Land and Building
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 • Taxation in the United States and Around the
World .
• The Equity Implications of Taxation: Tax
Incidence
• Tax Inefficiencies and Their Implications for
Optimal Taxation
• Taxes on Labor Supply
• Taxes on Savings
• Taxes on Risk Taking and Wealth
• Corporate Taxation
• Fundamental Tax Reform
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Five Important Innovations of Tax Policy

1. It is a possible to introduce more progressivity in a value

added tax system, but that its benefits have to be weighted
against significant extra vulnerability to evasion.
2. Significant differentiation among rates of import tariffs can
lead to huge economic inefficiencies by giving vastly different
degrees of effective protection to different activities.
3. Personal income tax rates above 35 to 40 percent are very
hard to justify in light of their efficiency and incentive costs.

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Five Important Innovations of Tax Policy
(Cont’d)

4. Labor is likely to bear the burden of any unilateral

rise in the rate of tax on the income of
corporations (or businesses in general), once an
open-economy setting is put in place.

5. It is much easier to index a tax system for inflation

than people think. By its nature full indexation
promotes both equity and efficiency.

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 Pattern of Tax Revenue Collection
(Approximation)
Category of Countries Ratio of Tax Revenue to GNP
i) Low Income countries 15%
(per capita income Less
than $400)

ii) Low Middle income 20%

(per capita income $400 to
$1,600)

iii) Upper Middle income 30%

iv) High Income 45%
Industrialized countries

(Source: Wagner's Law – State takes an expanding share of GNP as per

capita incomes rise.)
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    Pattern of Tax Revenue Collection
Country GNP/Capital Rev/GDP Non-tax Rev/Rev
YEAR US $ 1999 1997 1997
Nepal 220 12.60% 13.65%
Bolivia 1010 24.35% 11.00%
Egypt 1400 28.95% 33.55%
Turkey 2900 21.95% 12.88%
Mexico 4400 19.10% 14.27%
Brazil 4420 37.30% 14.10%
Chile 4740 25.54% 17.33%
Kuwait 15000 46.90% 95.55%
Canada 19320 40.19% 17.05%
Italy 19710 45.40% 11.02%
UK 22640 39.13% 12.45%
Sweden 25040 58.90% 10.20%
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 Composition of Government Revenues

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 Composition of Government Expenditures

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 Principles to Evaluate a Good Tax System
Revenue Adequacy
• The taxes introduced should be sufficient to finance and fund the
government expenditure requirements over time.
• Tax revenues should increase at a rate equal to or greater than the growth of
GNP.

• The entire tax system should evolve as the economy changes.

• Inadequate revenues will force the government to resort to borrowing,

selling state assets or printing money (inflation).
• Deficit financing by domestic borrowing leads to the crowding out of
private sector credit given by commercial banks.
• Deficit financing by foreign borrowing is limited and economically
expensive.
• Deficit financing by Central Bank borrowing leads to inflation.
• High inflation usually leads to financial crises.
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 Principles to Evaluate a Good Tax System (Cont’d)
Stability
 The stability of tax revenues is important for good government.
 Revenue instability will cause new programs to be poorly
implemented.
 Stability in the tax rules and rates over time allows the private
sector to make long term plans more efficiently.
For the stability of a tax system, it is necessary that:
a. the legislation be well written to eliminate unintended tax
exemptions or deductions (loopholes)
b. the statutory rates of tax for each of the taxes are not so high as
to create powerful incentives to promote tax avoidance schemes
or to stimulate tax evasion activity
c. the tax revenue is adequate and grows in a consistent fashion
d. the tax system is simple and the combined cost of administration
and compliance is low
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Principles to Evaluate a Good Tax System (Cont’d)
Simplicity
 A Tax system should be simple so that it is easy to comply with
by taxpayers.
 Simplicity must apply to the administration of the law as well as
its legal structure.
 A complex tax system imposes high level of compliance costs on
tax payers and a high cost of administration on the government.

 Tax neutrality needed for growth.

 Growth comes about primarily through the expansion of savings
and expansion of investment into high return activities.
 The tax system should not create major distortions in
consumption and production behavior.
 A tax should not change the investment decisions by favoring
one set of investments over the others.
 The tax system should not create a disincentive to work.
 Well-designed tax systems should encourage competitive
growth in all sectors of the economy.
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Principles to Evaluate a Good Tax System (Cont’d)
Economic Efficiency
 A tax is efficient if the dead weight loss or efficiency cost is
small.
 High differential tax rates create larger economic efficiency
costs.
 The economic efficiency of a tax is an important consideration
when designing a tax system.
 Estimates of efficiency cost range from 5 to 150 percent of
additional tax revenues.

Low Administration and Compliance Costs

 A good tax system has low administration and compliance costs.
These costs are part of the economic cost of having a tax system.

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 PRINCIPLES OF TAX REFORM
Tax Systems Before and After Reforms
• Design of a tax reform depends on the existing elements of
the tax system
• Considerable differences in the existing tax policies and
economic systems of various countries
• The legislative and administrative set-up also vary from
country to country
• For the former Socialist economies of Eastern Europe and the
former Union of Soviet Socialist Republics a completely new
tax system has had to be created

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Tax Systems Before and After Reforms (Cont’d)
In many developing countries tax reforms need to concentrate only
on redesigning the existing tax system.
• Where reforms are extensive, their implementation could spread
over a number of years.
• Appropriate tax rules for the implementation is an important
component required for the success of a tax reform.
• A general understanding or consensus must be reached among
concerned economists, lawyers, and legislators for successful
legislation and implementation of these rules.

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Implementation of Reforms
• The actual implementation of a tax reform depends on the will of the
political leaders and the capabilities of the tax administration of the
country
• Political leadership has a major role in legislation of acts and rules
• Difficult to produce an integrated tax reform which has the support of all
the interest groups.
• Political leadership often seeks to influence the tax administration in
order to favor special interest groups, and this destroys tax systems
• The tax administration in a particular country may be slack and inactive
• For effective implementation of tax reforms, a prime requisite is that
reforms in the administrative setup keep pace with the changes in the tax
system and in the way the tax clients operates.

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• Design of tax reform will also depend on the type of tax which is the object
of reform
• Main categories of taxes:
a) Direct Taxes
* personal income tax
* business or corporate tax
b) Indirect Taxes
* sales taxes (Value Added Tax)
* excise taxes
• trade taxes
c) Property Taxes
* wealth tax
* estate and gift tax
* asset tax
d) User Charges
* users charges
Oct 17, 2022
* environmental taxes
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 Direct Taxes

A) Income Tax:

Before Reform After Reform

High top rates Top rates falling

(40%-75%) (20%-35%)
(Statutory Tax)
Many rates Very few rates

Many exemptions Most exemptions

eliminated
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 Direct Taxes (Cont’d)
B) Corporate Income Tax:

Before Reform After Reform

High marginal tax rates Convergence of top
statutory tax rates for
personal and corporate tax
systems
Incentives with tax Elimination of special
holidays incentives
Double taxation Integration of corporate
and personal taxes
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 Reduction of top marginal income rates since 1984
(Number in parentheses indicates the number of tax brackets)
Country Individuals Corporations
Before After Before After

Australia 60% (5) 49%(4) 46% 39%

Canada 34%(10) 29%(3) 28% 23%
Finland 50% 43% 52% 40%
Germany 56% 53% 56% 50%
Portugal 41/48% 37% 60/68 45%
Barbados 60% 50% 45% 35%
Colombia 49% 31% 40% 30%
El Salvador 60% 35% 30% 35%
Guatemala 42% 34% 48% 34%
Jamaica 58% 33% 45% 33%
New Zealand 66% (5) 33%(3) 45% 28%
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 Reduction of top marginal income rates since 1984
(Number in parentheses indicates the number of tax brackets)

Country Individuals Corporations

Before After Before After

Zambia 80% 35% 50% 35/45

Denmark 73% 68% 40% 50%

U.S.A. 50% 28% 46% 34%

Indonesia 45% 35% 45% 35%

Singapore 45% 33% 40% 33%

Botswana 75% 50% 35% 40%

Mauritius 70% 35% 66% 35%

U.K. 60% 40% 52% 35%

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 Indirect Taxes
A) Sales Tax:

Before Reform After Reform

Many rates Value Added Tax
(one positive rate and zero
rate)
Many exemptions Small number of
exemptions
Narrow base Broad base plus a selective
number of excise taxes
(cigarettes and liquor etc.)
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 Indirect Taxes (Cont’d)
B) Trade Taxes (Import Duties):
Before Reform After Reform
High tariff rates Top rates lowered
Target around the world for a
single rate. In free trade areas the
target rate is zero.
Wide dispersal among rates Fewer rates
(in India 90 different tax rates on
steel alone)
Quantitative controls No quotas

• While in 1950 no country had a Value Added Tax, by 1993 more than 80
countries had adopted some form of VAT Tax
• By 2001, over 120 countries have introduced VAT
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TAX INCIDENCE

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 Progressive Income Tax
The progressive income tax relieves some
of the inflationary pressures that might
otherwise arise when output increases
above its potential during an economic
expansion

Conversely, when the economy is in a

recession, real GDP declines but taxes
decline faster, so disposable income does
not fall as much as real GDP  it cushions
declines in disposable income, in
consumption, and in aggregate demand

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Taxes in Indonesia
A useful instrument for all 3 of govt’s
functions
Most important revenue needs to be raised
Should be equitable
Vertical equity
Horizontal equity
And economically efficient manner
Minimize tax “costs”

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Effects of different taxes
Can be divided into 2 groups:
Direct vs. indirect
Indirect taxes
VAT, contribute significant of tax revenue
Is difficult to avoid => economically efficient
Zero rating on basic commodities also make VAT
vertically equitable
However can be regressive

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 Direct taxes
Personal income tax and corporate
tax
Together ± 60% of tax revenue raised
Personal income tax
is vertically equitable => its
progressive
Inefficient => its easier for wealthy to
find ways of avoiding tax
Fiscal drag: adjusting tax brackets to
account for nominal changes in income
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