3. Characteristics of a good tax system

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Read the text and remember the criteria for evaluating a tax system:

Nobody likes taxes, but taxes are necessary if the govern-ment is to provide public goods and services and if it is to redis-tribute income to create a ‘better’ income distribution. At times, it seems that everybody wants more public services but to pay less for them. This can be done if the government improves its effi-ciency, and there have been significant increases in efficiency.

While the design of the tax system is a perennial subject of controversy — views of how to balance the equity-efficiency trade-off naturally differ markedly — there is broad consensus on the five principles of a good tax system.

Fairness. In most people’s minds the first criterion is fair-ness. But fairness is not always easy to define. In trying to define fairness, economists focus on two principles: horizontal equity, which says that individuals who are in identical or similar situa-tions should pay identical or similar taxes, and vertical equity, which says that people who are better off should pay more taxes.

Efficiency. The second criterion for a good tax system is effi-ciency. The tax system should interfere as little as possible with the way the economy allocates resources, and it should raise revenue with the least cost to taxpayers. Very high taxes may discourage work and saving, and therefore interfere with the efficiencyof the economy.

Sometimes, taxes can be used to improve economic effi-ciency or to advance broader social purposes: taxes on pollution can improve the environment; taxes on cigarettes discourage smoking, leading to improved health. Such taxes are said to yield a ‘double dividend’, improving overall efficiency or promoting social purposes and generating revenue at the same time.

Administrative Simplicity. The third criterion is administra-tive simplicity. It is costly — to the government and to those who must pay taxes — to collect taxes and administer a tax system. In

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addition to the costs of running the IRS (Internal Revenue Service, the USA), billions of hours are spent each year in filling out tax forms, hours that might be spent producing goods and services or enjoyed as additional leisure time. Billions of dollars are spent by taxpayers and by the IRS on accountants and lawyers in the annual ritual of preparing and processing tax forms. Finally, with a good tax system, it should be difficult to evade the taxes imposed.

Flexibility. The fourth criterion is simplicity. As economic circumstances change, it may be desirable to change tax rates. With a good tax system, it should be relatively easy to do this.

Transparency. The fifth criterion is transparency. A good tax system is one in which it can be ascertained what each person is paying in taxes. The principle of transparency is analogous to the principle of ‘truth in advertising’. Taxpayers are consumers of public services. They should know what they (and others) are paying for the services they are getting.