 1.2.

Objectives and principles of taxation

 objectives of taxation -what is intended to

be realized through taxation;
 principles – rules/criteria followed in
formulating a tax policy proposal or
evaluating an existing tax system;
1.2.1. Objectives of taxation

1. Taxes influence economic activities:

◦ Labor: The decision to work or enjoy leisure

◦ Investment: location choice etc
◦ Saving: choice between saving and consumption

2. Objectives of taxation may differ

between developed and developing
countries.

3. A tax system by itself cannot be

expected to achieve all the goals fully. It has
to fit in the overall framework of policies
and measures of the government.  
 Objectives of taxation may include:
 revenue for the government;
 employment generation through promotion of
labor intensive techniques;
 Removal/reduction of regional inequalities;
 reducing the gap between the poor and rich;
 proper allocation of resources to enhance social
well being;
 Discourage undesirable behavior/correcting
externalities;
 Stabilize the economy/influence aggregate
demand;
 encourage savings and investment etc.
 Adjustment of the distribution of income and
wealth to conform with what society considers a
fair state of distribution;

 Reduce the inequality among citizens

 There are different redistribution fiscal devices:

 (1) a tax-transfer scheme: progressive taxation of

high income earners with a subsidy to low income
households;
 (2) progressive taxes used to finance public
services (such as public housing) benefiting low
income households.
 (3) a combination of taxes on goods purchased
largely by high income consumers with subsidies to
other goods which are used mainly by low-income
consumers.
 2. Allocation function

 Relates to the process by which total

resources are divided among needs(goods
and services);
 Allocation of scarce resources among uses
to maximize citizens’ welfare;
 Tax measures should be designed to lead to
proper allocation of resources which in turn
would lead to the maximum possible use of
resources.
Tax measures should not cause taxpayers to
shift resources from higher to lower valued
uses in an effort to reduce tax liability;
Shifting resources to lower valued uses may
result in costs (losses) – efficiency costs

Efficiency costs are caused by changes in

behavior;
Redistribution and allocation (efficiency)

 redistribution inevitably involves an

efficiency cost;
 note that:

◦ (1) any given distributional change should be

accomplished at the least efficiency costs; and
◦ (2) a need exists for balancing conflicting equity
and efficiency objectives.
3. Stabilization function (influencing
aggregate demand)
maintaining high employment, a reasonable

degree of price level stability and an

appropriate rate of economic growth, with
allowances for effects on trade (soundness of
foreign accounts) and on the balance of
payments.
 The overall level of employment and prices
in any economy - aggregate demand;

 The level of demand is the function of

spending decisions;

 These decisions in turn depend on many

factors, such as past and present income,
wealth position, credit availability and
expectations;
 Scenario 1: the level of expenditures
may be insufficient to secure full
employment of labor and other resources.

 Expansionary measures to raise aggregate

demand are needed.
 Scenario 2: expenditures may exceed the
available output under conditions of high
employment and thus may cause inflation.

 In such situations, restrictive measures are

needed to reduce demand.
 fiscal policy can be used to mitigate these
problems.

 Raising pubic expenditures will be

expansionary as demand is increased,
initially in the public sector and then
transmitted to the private sector.

 Tax reduction, similarly may be

expansionary;
 In periods when expenditures exceed the
available output, restrictive measures are
needed to reduce demand.

 Increasing tax burden and reducing the

income available for spending by taxpayers
may be considered;
 1.2.2. Principles of taxation
 There are various criteria (principles) that

can be followed in evaluating a tax policy

proposal (tax structure);
 some of them are in conflict against each

other;
 Some of the criteria such as equity are

subjective;
 People may disagree on the relative

importance of the criteria;

 Adam Smith (1776, ed 1952) calls them
canons of a tax system.
 There are four canons of taxation as

prescribed by Adam Smith (1776, ed 1952).

 Equity
 Economy
 Certainty
 Convenience
 Smith’s canons were later extended by other
writers to include:

 Productivity
 Buoyancy
 Flexibility
 Simplicity etc
Equity

One important principle of a good tax

system is fairness (equity).
Everyone agrees that the tax system should

be equitable, i.e., that each taxpayer should

contribute his/her “fair share” to the cost of
government.
There is no agreement on how the term “fair

share” should be defined.

 What a “fair share” means in practice the
subject of endless contention and debate.

 There are two schools of thought:

◦ The benefit principle

◦ The ability to pay principle
 Benefit principle
 an equitable tax system is one under which

each taxpayer contributes inline with the

benefits which he/she receives from public
services.
 the truly equitable tax system will differ

depending on the expenditure structure.

 Ability to pay principle
 the tax system is viewed by itself

independent of expenditure determination.

 A given total revenue is needed and each

taxpayer is asked to contribute in line with

his/her ability to pay.
 leaves the expenditure side of the public

sector untouched;
 The ability to pay principle relates taxes
paid to some measure of ability to pay, such
as overall wealth, income or consumption;
 No agreement on which one is best measure

of ones ability to pay;

 Ability to pay may vary depending on the

measure chosen;
 Limitations of both principles
 For the benefit principle to be operational,

expenditure benefits for particular

taxpayers must be known.
 Although the benefit principle may be

applied directly to the finance of certain

governmental functions, it does not solve
the general problem of tax-structure
design.
 It fails to provide the revenue needed to
finance transfers- redistribution role of
taxes is not realized.

 For the ability to pay approach to be

applicable, we must know how this ability is
to be measured.