The Income Tax

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A central purpose of the tax system in any country is to distribute the cost of financing government activities as fairly as possible among the population. As emphasized in the previous text, "fairness" is inherently a subjective concept; as a rule, however, a fair distribution of taxes is considered to be one that imposes taxes on people in accordance with their ability to pay, as measured by some socially acceptable index of economic capacity. The personal income tax is the only significant component of the tax system which has at least the potential of being completely "fair," in the sense that the taxes paid by different individuals can be explicitly related to their society determined ability to contribute to the financing of government activity.

Other taxes – those on luxury consumption, for example -may in practice turn out to be progressive in that those with higher incomes will, on average, pay a larger proportion of their incomes in tax than those with lower incomes. However, such taxes may treat taxpayers with the same incomes but different consumption patterns very differently. Only the personal income tax takes explicitly into account those personal characteristics of the taxpayer which are considered most relevant to his ability to pay. Any tax reform concerned with improving the equity of the revenue system must therefore pay particular attention to the structure and functioning of the personal income tax.

The essential role 01 the personal income tax in the tax system is thus to treat different people equitably, as equity is defined in the society in question. The ideal is to tax those with the same capacity to pay at the same rate, while levying heavier taxes on those with greater capacity than on those with lesser capacity. In view of the existence in most countries of important taxes that do not have these attributes, it may also be considered desirable to increase the progressivity of the income tax to offset the regressivity of the rest of the tax system. At the same time, of course, the desire to encourage saving and entrepreneurial activity acts as a check on the progressivity of the tax, as may political conditions.

An additional virtue of the personal income tax, particularly one that is effectively progressive in its incidence, is that increased reliance on it for revenues may, at least in principle, add to the elasticity of the revenue structure and hence reduce the need to recur to deficit financing of expenditures. Increased reliance on the personal income tax is in theory an important means of increasing both the elasticity and the progressivity of the tax system.

The effect of the income tax on economic incentives is in part determined by its coverage of economic activity. If important sectors (such as agriculture) are, in effect, tax-free, then more resources will tend to flow to these sectors than would otherwise be the case, to the disadvantage of taxed sectors such as manufacturing. Unless such distortions in economic activity are consciously intended (e.g., for political reasons) this result is undesirable. Moreover, the knowledge that some forms of income are taxed more lightly than others may act as a brake on the political acceptability of the income tax, and, indeed, of taxes generally. So long as people feel that others are getting away without paying their "fair share" of taxes, their willingness to meet their own tax obligations is greatly reduced. For both these reasons, an important objective of income tax reform in developing countries is to extend the effective coverage of the tax to a much broader segment of the economy. In many countries what is most needed to achieve this aim is strengthening and restructuring of income tax administration.