Lecture 6Taxation. Romanian Tax System

General Theory on Taxation

ANDREEA STOIAN

PROFESSOR OF FINANCE, PHD

DEPARTMENT OF FINANCE AND CEFIMO

BUCHAREST UNIVERSITY OF ECONOMIC STUDIES

Adam Smith’s Four Principles of TaxationThe subjects of every state ought to contribute towards the support of the government, as nearly aspossible … in proportion to the revenue which they respectively enjoy under the protection of thestate. (Principle of equity)

The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time ofpayment, the manner of payment, the quantity to be paid, ought all to be clear and plain to thecontributor, and to every other person. Where it is otherwise, every person subject to the tax is putmore or less in the power of the tax-gatherer, who can either aggravate the tax upon any obnoxiouscontributor, or extort, by the terror of such aggravation, some present or perquisite to himself.(Principle of certainty)

Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenientfor the contributor to pay it. (Principle of simplicity)

Every tax ought to be so contrived as both to take out and keep out of the pockets of the people aslittle as possible, over and above what it brings into the public treasury of the state. (Principle ofefficiency)

Smith, Adam (1776), The Wealth of Nations, Book V, Chapter II

What is tax fairness?

• The principle that groups with more resources should pay higher taxes than groups with fewer resources

• Concerns over vertical equity could be motivated by a utilitarian social welfare function that calls for redistribution from lower to higher marginal utility of consumption groups in society

Vertical equity

• The principle that similar individuals who make different economic choices should be treated similarly by the tax systemHorizontal

equity

Measuring vertical equity

• Effective average tax rate must rise with the income, so that the rich pay a higher share of their income in taxes that do the poor

Progressive tax system

• Tax system in which the effective average tax rate does not change with the income

Proportional tax system

• Tax system in which effective average tax rates fall with income

Regressive tax system

Modern Principles of Taxation (I)Neutrality: Taxation should seek to be neutral and equitable between forms of business activities. A neutral taxwill contribute to efficiency by ensuring that optimal allocation of the means of production is achieved. Adistortion, and the corresponding deadweight loss, will occur when changes in price trigger different changes insupply and demand than would occur in the absence of tax. In this sense, neutrality also entails that the taxsystem raises revenue while minimizing discrimination in favor of, or against, any particular economic choice. Thisimplies that the same principles of taxation should apply to all forms of business, while addressing specificfeatures that may otherwise undermine an equal and neutral application of those principles.

Efficiency: Compliance costs to business and administration costs for governments should be minimized as far as possible.

Certainty and simplicity: Tax rules should be clear and simple to understand, so that taxpayers know where they stand. A simple tax system makes it easier for individuals and businesses to understand their obligations and entitlements. As a result, businesses are more likely to make optimal decisions and respond to intended policy choices. Complexity also favors aggressive tax planning, which may trigger deadweight losses for the economy.

Modern Principles of Taxation (II)Effectiveness and fairness: Taxation should produce the right amount of tax at the right time, whileavoiding both double taxation and unintentional non-taxation. In addition, the potential for evasionand avoidance should be minimized. Prior discussions in the Technical Advisory groups (TAGs)considered that if there is a class of taxpayers that are technically subject to a tax, but are neverrequired to pay the tax due to inability to enforce it, then the taxpaying public may view the tax asunfair and ineffective. As a result, the practical enforceability of tax rules is an importantconsideration for policy makers. In addition, because it influences the collectability and theadministerability of taxes, enforceability is crucial to ensure efficiency of the tax system.

Flexibility: Taxation systems should be flexible and dynamic enough to ensure they keep pace withtechnological and commercial developments. It is important that a tax system is dynamic and flexibleenough to meet the current revenue needs of governments while adapting to changing needs on anongoing basis. This means that the structural features of the system should be durable in a changingpolicy context, yet flexible and dynamic enough to allow governments to respond as required to keeppace with technological and commercial developments, taking into account that future developmentswill often be difficult to predict.

Tax incidence – Who bears the tax?

Statutory incidence: the burden of a tax borne by the party

that sends the check to the government

Economic incidence: the burden of taxation

measured by the change in the

resources available to any economic agent as

a result of taxation

Tax incidence: assessing which

party (consumers or producers) bears the true

burden of a tax

Economic incidence

Tax wedge: the differencebetween what consumers payand what producers receivefor a transaction

Tax incidence – the side of the market on which the tax is imposed is irrelevant to the distribution of tax burden

Tax incidence – depends on the elasticity of the supply or demand

Tax incidence - summaryThe statutory burden of a tax does not describewho really bears the tax

The side of the market on which the tax is imposedis irrelevant to the distribution of tax burden

Parties with inelastic supply or demand bear taxes;parties with elastic supply or demand avoid them

Taxation and economic efficiency

Deadweight loss: the reduction inthe quantity purchased due toincrease in taxation. It is caused byindividuals and firms makinginefficient consumption andproduction choices in order to avoidtaxation

The inefficiency of any tax isdetermined by the extent to whichconsumers and producers changetheir behaviour to avoid the tax.