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Friday March 29, 2024

Equality key to broadening tax base

By Editorial Board
October 31, 2021

The debate on a good taxation system is centuries old. All the developed and developing countries require strong and perpetual mobilisation of tax revenue for meeting growing demand for public goods and alleviation of poverty.

The capacity of a government spending on public service delivery, including health and education, largely depends upon the inflow of domestic resources through taxation. Governments in different countries frequently revamp their taxation systems to discern the leak in the revenue stream. Developing countries are more concerned about the low or stagnated tax GDP ratio. Low tax GDP ratio is an important indicator to analyse the tax effort made by a government for realising the actual tax potential of an economy. In this scenario, the responsibility lies with the sitting government to make serious efforts to increase the tax base for reducing the tax gap.

In this context, theories of taxation given by the pundits of public economics are considered benchmarks for formulation of a taxation policy for a country. For that purpose, the canons of taxation described by Adam Smith in his famous book “The Wealth of Nations” are very significant to tackle the distortions arising as a result of levy of any direct or indirect tax. These canons of taxation define numerous rules and principles upon which a good taxation system can be built. Although these canons of taxation were centuries old, they are still used as the foundation of a discussion on the principles of taxation. Four main canons of taxation propounded by Adam Smith are Equality, Certainty, Convenience, and Economy.

The first canon i.e. equality states that the burden of taxation must be distributed equally or equitable among taxpayers. The canon of equality demands that everyone in the state is subjected to pay taxes for the economic activity in accordance with his or her ability to pay. The equity in taxation rests on the basic notion of ‘Ability to Pay.

In the year 1776, Adam Smith wrote about the canon of equality that “the subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities.” Adam Smith argued that tax should be based on the ability to pay tax.

Another noted 19th-century American economist Henry George wrote in his book, “Progress and Poverty” (1879) “The mode of taxation is, in fact, quite as important as the amount. As a small burden badly placed may distress a horse that could carry with ease a much larger one properly adjusted, so a people may be impoverished and their power of producing wealth destroyed by taxation, which, if levied in any other way, could be borne with ease.”

This was the idea given by Henry George in the context of discussing the significance of one of the canons of taxation i.e. equality. He stressed the significance of the mode of taxation as it affects the growth of economy. Taxation without adhering to the principle of equality would retard the process of producing wealth. People’s spending power would be squeezed with contracting propensity to save and invest. An unjust taxation system deprives people of opting for a better standard of living and keeps them trapped in a vicious circle of poverty leading to a myriad of financial difficulties.

Nicholas Kaldor is also another renowned economist who also advocated that an important criterion by which any tax system must be judged is its degree of equity, both horizontal and vertical. Kaldorian taxation reform emphasised the principle that the taxation of individuals should be based upon their taxable capacity. He strongly believed that there are more inequalities in income and wealth distribution in developing countries as compared to developed countries of the world. He further concluded that the rich in the developing countries have a higher propensity to consume than those in the developed countries. Therefore, he advocated that the taxation should be made upon the principle of ability to pay tax in accordance with the canon of equality.

Canon of equality in taxation requires taxation of all economic activity without giving any preferential treatment in the form of exemptions, concessions, rebates, discounts, or tax holidays. By opting for the principle of equality, the distortions arising in the forms of high inflationary pressures, heavy reliance on withholding taxes, misuse of tax exemptions/concessions, unequal distribution of income and wealth, high budget deficit, and high Debt-to-GDP ratio can be avoided. The principle of equality is closely linked with the tax base. More adherences to the canon of equality will result in the broadening of the tax base. Broadening of tax base not only ensures the maximisation of tax revenue but also mitigates the tax burden on taxpayers. On the contrary, a narrow tax base reflects the large tax gap, meaning thereby, huge tax evasion exists which is a deadweight loss. For the government to meet its tax revenue targets with a narrow tax base has to rely on taxing the already taxed people or imposition of a new tax. The imposition of a new tax or raising an old one can backfire, resulting in insufficient or no gains in government revenues due to a decline in demand for the goods or services being taxed. This is a situation of deadweight loss of taxation which disrupts the balance between demand and supply.

In a nutshell, the non-observance of the canon of equality has resulted in a narrow tax base which may be regarded as a deep-rooted unfairness in the tax system. Those who do not get documented or pay no tax or less tax are required to be brought into the tax net even through coercive measures. The canon of equality cannot be ensured without expanding the tax base. An unjust taxation system will disrupt the whole dynamics of the economy and could be detrimental to economic growth and stability. —Faisal Asghar (The writer is a senior Income Tax official)