Canon of taxation - For Grade 9 students

Canons of Tax - What Makes a Good Tax?

Income Tax Theories - Canons of Taxation - What makes a good tax?

The 'Canons of taxation' were first developed by Adam Smith as a set of criteria by which to judge taxes. They are still widely accepted as providing a good basis by which to judge taxes. Smith's four canons were:

1. The cost of collection must be low relative to the yield
2. The timing and amount to be paid must be certain to the payer
3. The means and timing of payment must be convenient to the payer
4. Taxes should be levied according to ability to pay

Modern economists have added three more canons to these to update and extend them:

5. A tax must not hinder efficiency or should involve the least loss of efficiency
6. A tax should be compatible with foreign tax systems (in the UK's case, with Europe's)
7. Tax should automatically adjust to changes in the rate of inflation (particularly important in high inflation economies)

The best taxes will tie in with all these. The worst taxes won't!

Progressive or Regressive - Who Pays What?

One of the 'Canons of taxation' developed by Adam Smith said that a tax should be linked to 'ability to pay'. Income tax clearly ties in with this because, as we can see from the explanation of income tax, the higher a person's taxable income, the greater the rate they pay. This means that income tax is progressive. In other words, the more people earn, the greater the proportion of their income they pay in tax.

A regressive tax, on the other hand, is a tax where the more people earn the less the tax represents as a proportion of their income. In other words, regressive taxes will hit less-well-off people harder than the better-off. The full definitions are:

Progressive tax - a tax that represents a greater proportion of a person's income as their income rises. In other words, the average rate of taxation  rises.

Regressive tax - a tax that represents a smaller proportion of a person's income as their income rises. In other words, the average rate of taxation  falls.

Proportional tax - a tax where the percentage of income paid in taxation always stays the same. In other words, the average rate of taxation  is constant.

The balance of these taxes can have a significant effect on income distribution in an economy. If a government chooses to switch the balance of taxation from progressive to regressive taxes then the less-well-off in society will be harder hit.

The Laffer Curve - Who Pays How Much?

Income Tax Theories - The Laffer Curve - Who pays how much?

The Laffer Curve is aptly named after Professor Art Laffer. He was an advisor to President Reagan in the early 1980s, but, despite that, he has become quite well known through his 'curve'! He suggested that, as taxes increased from fairly low levels, tax revenue received by the government would also increase. However, as tax rates rose, there would come a point where people would not regard it as worth working so hard. This lack of incentives would lead to a fall in income and therefore a fall in tax revenue. The logical end-point is with tax rates at 100% where no one would bother to work (understandably!) and so tax revenue would become zero.

This is illustrated by the Laffer Curve:

T* represents the optimum tax rate where the maximum amount of tax revenue can be collected. Laffer and other right-wing economists used the curve to argue that taxes were currently too high and should therefore be reduced to encourage incentives and harder work (a supply-side policy  ). Others argue that we are already well to the left of T*. Why not try to test the theory on the Virtual Economy model ? It should be a Laff - er minute!!