faculty of economics and political sciences cairo university

Faculty of Economics and Political SciencesCairo University

Tax regimes in Egypt & European countriesLectures three and Four

Dr. Mohamed Zaky

Tax is a financial means by which governments finance their expenditure by imposing charges on:

Citizens Corporate entities

Tax Definition

Tax Definition

• Taxation is a payment levied by government for which no good or service is received directly in return.

• that is, the amount of tax people pay is not related directly to the benefit people obtain from the provision of a particular good or service.

• In contrast, duties payment are related to direct benefit.

Tax Base

• The value of all assets that a government may tax. The tax base may increase for a number of reasons, particularly with the creation of wealth or when persons with high income move to an area.

• The tax base is particularly important to local governments because persons with large amounts of assets can move in and out with relative ease.

• The tax base is also the reason that government revenues tend to increase during economic growth and shrink during recessions.

Vertical equity

Horizontal equity

Efficiency

Effectiveness

Simplicity, Transparency & Certainty

Consistency & coherence

Flexibility

Enforceability

Principles of sound tax policy

Mainstream public sector Economists do not agree on which tax base best satisfies the principle of horizontal equity.

They do agree, however, on the proper way to think about what the ideal tax base should be.

The line of reasoning from horizontal equity to the ideal tax base always relies on the same three principles of tax design.

Principles of Sound Tax PolicyHorizontal equity

Taxpayers in the same economic circumstances should receive equivalent treatment.

Principles of Sound Tax Policy

Horizontal equityThe three principles of Tax Design from horizontal equity prospective:

The first principle of tax design is that People ultimately bear the tax burden of any tax no matter what is actually taxed.

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The three principles of Tax Design form horizontal equity:

The second principle of tax design is that individuals ultimately sacrifice utility when they pay general tax, so that the ideal tax base would be individual utility levels.

In 1976, Martin Feldstein Clarified what horizontal equity must mean to mainstream, neoclassical economists.

Feldstein's Horizontal Equity principle: Two people with the same utility before tax have the same utility after tax.

This is the only sensible economic interpretation of equal treatment of equals under a sacrifice principle of taxation.

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Feldstein also proposed a minimum condition for the unequal treatment of unequals – no reversals- that has also gained universal acceptance among neoclassical economists.

Feldstein’s Vertical Equity Principle (No Reversals): If a person one has greater utility than person two before a tax, then person one must have greater utility than person two after tax.

Feldstein’s two principles can only be guaranteed if utility is the tax base.

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The three principles of Tax Design form horizontal equity:

The third principle of tax design is that the ideal tax base as the best surrogate measure of utility.

Taxing utility is impossible, so the third principle of tax design is that the tax base should be the best surrogate measure of utility.

Under this ideal tax base, the best surrogate for utility, two people with an equal value of the tax base are equals and should pay the same tax.

This is as close as the tax practitioner can come to Feldstein’s principle of equal utility before tax: equal utility after tax in the quest for horizontal equity.

Mainstream economists agree on the three principles, but they have not reached a consensus on what constitutes the best surrogate measure of utility. The two main contenders are income and consumption.


Horizontal equityHaig – Simons Income

Haig and Simons argued that purchasing power is the best surrogate measure of utility.

This led them to propose income defined as the increase in purchasing power during the year as the ideal tax base for a tax levied annually.

Using standard national income accounting terminology, Haig- Simons income can be defined as: Haig- Simons income= Consumption + Increase in net worth.

Haig- Simons Income= Consumption + Saving+ Capital Gains.

Or Haig- Simons Income= Personal income+ Capital Gains (Notice that the Haig- Simons definition uses personal income tax rather than disposable income because the former includes personal income tax which is originally part of the tax base).


Horizontal equityHaig – Simons Income

Having determined that Haig- Simons income is the best surrogate measure of utility, Horizontal equity is then defined as follows:

Horizontal equity:

Two people with identical amounts of Haig- Simons income are equals and should pay the same tax.

Similarly, two people with different amount of Haig- Simons income are unequals and should pay different taxes by the principle of vertical equity.

The difference in their taxes depends on the tax structure applied to Haig- Simons income.


Horizontal equityCriticisms of Haig – Simons Income

Haig – Simons Income is perfect surrogate measure of utility if people have the same tastes, abilities, and opportunities; otherwise, it may be a very poor surrogate.


Consumption or Expenditure as the Preferred Alternative:

Kaldor’s argument:

The only twist is that Kaldor’s argument is seen today as a dynamic efficiency argument, not an equity argument.

Models find that replacing an income tax with a consumption tax leads to huge steady state increases in output per person. The increase in output results from the increase in saving, investment, and productivity under the consumption tax, exactly as Kaldor argued. This is seen as a powerful efficiency argument in favor of a consumption tax.


The burden of taxation should be shared in accordance with taxpayers' respective ability to pay, sometimes referred to as 'the ability to pay' principle.

Vertical equity

Once the ideal tax base has been determined, the quest for vertical equity centers on the design of the tax structure. Should the tax be levied at a single rate- a flat rate – or should the rates be graduated, rising with income? Should some minimum amount of income be exempt from taxation?Should taxpayers be allowed to deduct certain items of income or expenditure in computing their taxable income?The answer to these questions determine exactly how unequally unequals are treated under the tax laws, which is the central issue of vertical equity.


Vertical equity

Taxes should be progressive, proportional, or progressive are the three broad indexes of vertical equity.The most common definitions of these indexes are in terms of the average tax burden across individuals.Let: Yi = value of the ideal tax base for the individual i.Ti = the burden of the ideal tax base on individual i. Here the average tax burden on individual i is the ratio Ti/yi. Rank order individuals on the basis of Yi and ask how average tax burden varies as Yi increases:• The tax is progressive if Ti/Yi increases as Yi increases. • The tax is proportional if Ti/Yi remains constant as Yi increases.• The tax is regressive if Ti/Yi decreases as Yi increases.

The percent of income paid as tax rises as the income amount rises

Progressive tax

Regressive tax

Proportional tax

The percent of income paid as tax decreases as the income amount rises

The percent of income paid as tax stays the same as the income amount rises


Efficiency

Generally taxes should be neutral to ensure that investment decisions take into account the 'best' location from an economic perspective

However, taxation policy may be used to correct 'market failures’

Locational inefficiency

Investments are not placed where the productivity of capital is the highest.

Determining whether a tax policy is correcting a market failure, or is inefficient can be difficult.

Specific tax incentives


Simplicity, transparency and certainty:

The simpler the tax base, the lower the administrative/compliance costs for both administrations and business.

Measurement difficulty: international comparisons, measuring the incentive provided by a tax base which has 'low' costs against a 'high' cost are difficult.

The rules must also be certain and clear which links in to the requirement for transparency.

S

T

C Certainty assists business planning and revenue detection certainty for administrations, for example if the rules governing loss-offset are unclear then neither business nor government can predict tax payments and revenues. The rules must also provide an appropriate level of protection against tax evasion and the unacceptable use of purely artificial tax avoidance schemes.

Transitional costs of introducing a new tax base need careful consideration.


Neutrality: Taxation should seek to be neutral and equitable between forms of commerce.

Business decisions should be motivated by economic rather than tax considerations.

Taxpayers in similar situations carrying out similar transactions should be subject to similar

levels of taxation.

• Efficiency: Compliance costs for taxpayers and administrative costs for the tax authorities

should be minimized as far as possible;

• Certainty and simplicity: The tax rules should be clear and simple to understand so that

taxpayers can anticipate the tax consequences of a transaction, including knowing when,

where and how the tax is to be accounted;

• Effectiveness and fairness: Taxation should produce the right amount of tax at the right

time. The potential for tax evasion and avoidance should be minimized while keeping

counter-acting measures proportionate to risks involved;

• Flexibility: The systems for taxation should be flexible and dynamic to ensure that they keep

pace with technological and commercial developments;

The rules of a tax base must be easy to enforce as an unenforceable system is unlikely to be either equitable or neutral.


Consistency & coherence:

Flexibility:

Enforceability:

When two transactions have the same commercial result they should have the same tax result – i.e. commercial decisions on the structuring of transactions should not be distorted by taxation considerations, for example the finance leasing of plant should arguably produce the same post tax profits as the purchase of plant.

Markets and business practices change over time that’s why the tax base should be responsive and be capable of change as well

A tax collected by an intermediary (such as a retail store) from the person who bears the ultimate economic burden of the tax (such as the customer). It can be shifted by the taxpayer to someone else. An indirect tax may increase the price of a good so that consumers are actually paying the tax by paying more for the products.

Direct Versus Indirect Taxes :

Direct taxes

Indirect taxes

A kind of charge, which is directly imposed on the taxpayer & directly paid to the government by the persons (juristic or natural) & cannot be shifted by the taxpayer to someone else.

Or estate tax/death duty is a tax which arises on the death of an individual. A tax on the estate, or total value of money & property of a person who has died.


Direct taxes

Income tax Corporation tax

Property tax

Gift tax

Or 'house tax' is a local tax on buildings, appurtenant land & imposed on owners.

Inheritance tax


Indirect taxes

Customs duty Central excise duty Service tax

Sales tax VAT

Securities transaction tax

The practice of VAT executed by State Governments is applied on each stage of sale, with a particular apparatus of credit for the input VAT paid.


Allocation Effect

Distributive Effect

Administrative Costs

Built-in Flexibility and Stability

Growth Orientation

Progressive Advantage of Direct Taxes

Transparency of Direct Taxation

Environmental Benefits of Indirect Taxation

Advantages and disadvantages

The allocative effects of direct taxes are superior to those of indirect taxes.

When a particular amount is raised through a direct tax like income tax, it would imply a lesser burden than the same amount raised through an indirect tax like excise duty.

An indirect tax involves excessive burden as it distorts the consumer's preference regarding goods due to price changes.

Thus an indirect tax has an adverse effect on the allocation of resources than a direct tax.


Allocation effect

Direct taxes are progressive and they help to reduce inequalities. But indirect taxes are regressive and they widen the gap of inequalities.

Hence, direct taxes are regarded to be superior to indirect taxes in achieving a more equitable distribution of income and wealth. But this is not always true. Even indirect taxes can be made progressive by levying them on luxuries and exempting them on necessaries.

Both direct and indirect taxes are alternative methods of achieving any particular redistribution of income.


Distribution effect

The administrative costs of direct taxes are more than that of indirect taxes. Direct taxes are narrow based and has many exemptions. Indirect taxes can be conveniently collected and cost of collection is constant overtime. Indirect taxes are easier to administer than direct taxes.

From point of view of efficiency and productivity, indirect taxes are better. Indirect taxes are wrapped up in prices and hence they cannot be easily evaded. They are more productive as their cost of collection is the least.

Thus, from point of view of administrative costs, indirect taxes are relatively superior.


Administrative costs

Direct taxes are more flexible than indirect taxes. During a period of prosperity, direct taxes fetch more revenue as they are progressive. But indirect taxes are proportional and they do not fetch as much revenue as direct taxes.

Direct taxes help to reduce the inflationary pressure by taking away the excess purchasing power and hence they promote stability. But indirect taxes are inflationary.

Hence, from the point of stability, direct taxes are preferred to indirect taxes.


Built-in flexibility and stability

Indirect taxes are more growth oriented than direct taxes. Direct taxes, being progressive, reduce savings. When savings and investments are discouraged, economic growth is adversely effected.

Indirect taxes discourage consumption and increase savings. Indirect taxes on luxuries reduce conspicuous consumption and channelize resources in to growth oriented programs.


Growth orientation

One advantage of direct taxation is that it is easy to apply in a progressive manner.

Progressive taxes are a fair way of generating revenue, because multiple rates of taxation can be applied, based on the ability of the tax payer to pay the tax, especially if tax rates increase marginally.

For example, a government may apply income tax to earnings at a rate of 10 percent, for all income earned up to $20,000. Then it applies a rate of 15 percent to income over $20,000. A person earning more than $20,000 will pay tax at a rate of 10 percent on the first $20,000 earned, and only pays 15 percent on earnings over that amount.

Progressive, marginal, direct taxation is therefore fair because higher earners bear a greater part of the tax burden, based on their ability to pay higher rates of tax.


Progressive advantage of direct taxes

Direct taxes, which go directly by the person bearing the burden of the tax, are transparent taxes.

For example, when an employer deducts taxes from the wages of an employee, the employee can see the amount of tax deducted, as it is included on his or her wage statement, or pay-slip.

Self-employed tax payers can also see the amount of tax they need to pay to the government, when they complete their tax returns.

In a democratic country, tax transparency means that governments have to justify taxes they impose to their voters, and tax-paying voters always aware of the tax burdens imposed on them by politicians.


Transparency of direct taxation

Conclusion

From the allocation, distribution and stability perspective

From the productivity and economic growth perspective

Direct taxes

Indirect taxes

Indirect taxes

Indirect taxes

The use of both direct and indirect taxes is indispensable in modern public finance.

faculty of economics and political sciences cairo university

Documents

personal income tax

tax practitioner

tax burden

general tax

principle of tax design

ideal tax base

haig simons income

haig simons income haig