theory of taxation
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
Table of Contents
Chapter One – Introduction
1. Preface
4
2. Jurisdiction to impose Tax
6
The Social Treaty and the Origin of Taxing
6
Historical Development
7
The Purpose of Tax
8
"Normative Tax Structure" and "Tax Expenditures"
8
Taxing and Justice
10
Distribution of Tax Burden
13
Does tax breaches Fundamental Rights?
16
Chapter Two – Postulates
3. Terms
20
Tax Unit
20
Positive Tax
20
Negative Tax
20
Direct Tax
20
Indirect Taxing
21
4. Mandatory Payments
21
Definition of Tax
21
Price
22
Fee
22
Participation Fee
23
Municipal (propriety) Tax
23
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
5. Differentiating between Sorts of Mandatory Payments
24
The Tests for Differentiation
24
The significance of Differentiation
24
6. Public goods
24
7. Market Failures
25
8. Incidence of Tax
28
9. Principals of a Good Tax system
31
10. Neutrality in Taxing
34
11. Effective Tax
35
12. Efficiency of the Method of Taxing
36
13. The Search for a 'Just' Tax
37
Progressive Tax
37
Regressive Tax
39
Flat Tax
39
Tax Credits and Tax Deductions
40
Pigovian Taxing
41
14. Deferral
43
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
Chapter Three – Topics
15. Value Added Tax (VAT)
44
Introduction
44
Added Value
44
Methods of Imposing VAT
45
Further Problems with VAT
46
Battling VAT Evasion
47
Tax Regressivity
48
Tax Exemption as opposed to Zero Tax Rate
49
VAT and Non-profit organisations
49
16. Accountancy and Definition of Taxable Income
50
17. Taxing International Activity
52
Introduction
52
The Territorial Tax Method
53
The Residential Tax Method
54
Relief from Double Taxing
54
Issues in International Tax Planning
56
18. Corporate & Shareholders Taxing
59
Introduction
59
The Justification to impose Corporate Tax
59
The Full Transparency Model
60
The Double Taxing Model
61
The Corporate Value Model
62
Other Methods – Partial Interlacement
62
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
Chapter One – Introduction
1. Preface
In observing social organisations, it is possible to detect an identical pattern of behaviour: every organisation finances its activity via contributions from its members. No meaningful activity is possible without a budget, the more so, when funding the operations and budget of the country. Pursuant to an agreement, manifested in a ‘Social Treaty’ a large number of inhabitants were united under one state structure, to an end of achieving their goals as a group. By virtue of such agreement, they voluntarily took upon themselves to fund the activities of the state, i.e., its budget. Such funding was achieved through the state’s tax laws and mechanisms. At first glance, tax laws seem to compromise tax payers’ fundamental proprietary rights, but the state cannot avoid it - we will discuss the question of whether taxing forms injury to rights at all, or should the outcome be defined otherwise later below. It is worth noting that there are those who claim that funding states’ budgets is possible without recourse to taxing, but such claims are without merit. In the course of studying, we shall substantially analyse why that is so, but put simply, this is clear because the tax system is the very bedrock of the state’s budget.
Tax laws focus on tax collection methods and the distribution of the burden between all the state’s residents. They are responsible for creating order in the government’s tax revenues as its main mean of funding. Note, however, that attention and public debate surrounds mainly government spending, rather than its revenue, i.e., what does the government do with the money it has, or in other words - how is the budget divided between the various interests, and less dealing with questions of how does the burden calculates and how is tax collected. This leads us to the conclusion that benefits, granted to certain groups should, also by
4
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. virtue of the need for transparency, be granted through the state budget, rather than result from a tax benefit.
We have said that political, public and constitutional thinking focuses mainly on government spending and less on the collection of tax, which is forms government revenue. It follows that the fundamental questions, concerning distributive justice, social rights and efficiency, do not constitute a substantial part of public debate, although ostensibly, these issues are essential in determining how the burden of tax be distributed and are of significant social and sociological implications.
Today, public discourse on tax law increasingly takes precedent and focuses more on how tax is imposed, questions of distributive justice and recognition of social rights protection – such because the tax system is also designed to achieve goals of ‘redistribution’ of wealth in society. Although right wing economic literature support ‘freely market’ and refuses to consider redistribution, focusing on increasing total wealth, it clearly states that the only effective way to redistribution is through the tax mechanism.
Apart from these questions other questions also arise, those of justice in the distribution of the burden of tax and intergenerational justice - as the government finances its operations through borrowing, it creates a situation where the current generation enjoys services that government provides, whilst future generations are the ones who would fund them through tax that will be imposed on them.
Tax can affect all aspects of life: economic activity, supply and demand of work, organisation of business, capital structure of corporations, reinvestment of revenue, location of the business and residence, selection of industry in which the firm operates, encouragement of research and savings and many other effects. We shall see that at the foundation of the theory we shall study, stand rules that draw their essence from many doctrines, such as philosophy, accounting, public funding, economy, jurisprudence and more. This makes tax theory, complex, multi-disciplinary and even fascinating and interesting.
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
In conclusion of this part, we shall quote Benjamin Franklin, who said: “In this world nothing can be said to be certain, except death and taxes”. Therefore, we can only delay their introduction!!!
2. Jurisdiction to impose Tax
•
The Social Treaty and the Origin of Taxing
The Social Treaty is a political theory, written by philosopher Jean-Jacques
Rousseau and following Thomas Hobbes's theory of the State of Nature.
According to Hobbes, in the state of nature, humans live in independence of each other and do not maintain sufficient contact between them to create a state of peace or war and the natural state is one of perpetual ignorance that must be avoided. In this situation, there is no private property and the only property that is owned, are those things that no man wants. In this situation, the strong rules, not by virtue of legitimacy, but by power itself. "Man is free in this situation as much as his might takes him". He has no protection from others. We can compare this to the position of animals in the wild.
According to Rousseau, for this reason individuals communicate with each other by way of a social agreement, which regulates their way of life, to the end of achieving more with the help of others – more than they could achieve in the natural state. By force of the social treaty, each individual commits to his/her sovereign and waives his/her natural freedom, in exchange of which he/she secures civil freedoms and proprietary rights.
We can say that historically, when individuals started living in communities, they formed orderly government bodies, whose role included, among other things, protection of borders and maintaining the welfare and other interests of all residents. Consequently, there became a need to fund such activities and every
6
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. individual had to contribute his/her share, thereby becoming entitled to enjoy the services that government provides.
It is easy to understand therefore that the tax must not only be imposed by representatives of the people, the Legislature, it must also meet constitutional criteria of justice, equality, fairness, dignity and more. The role of the
Constitutional Court is to examine whether or not tax laws are the compliant with constitutional criteria. Thus, for instance, Constitutional Courts in the USA and
Germany have revoked tax legislation for non-compliance with constitutional criteria. •
Historical Development
The first recorded tax system is Egypt’s (2800-3000 BC). There is evidence that
Pharaoh taxed his people. The Bible also mentions taxes, Genesis 47:24 states:
“But when the crop comes in, give a fifth of it to Pharaoh. The other four-fifths you may keep as seed for the fields and as food for yourselves and your households and your children”. Tax types in ancient times mainly took the form of customs and production tax, mainly oil.
In the Roman Empire, tax was imposed on land (jugim). There is evidence of taxation in Europe of the 17th century. There is also evidence of a taxation rate of
15% - 20%, imposed in France, the Netherlands and Scandinavia. In times of war in the 18th century and early 19th century tax rates increased significantly, as war became more expensive and governments became more centralised.
Over time the ancient taxation mechanism evolved into an elaborate system, which enforced clear rules on the identity of taxpayers, when are they due and for what. Although this was done over many years, the principle was the same in every village, kingdom and empire in human history. Residents paid a tax to secure security and enjoy the rights and services, provided by the governing body, to which they were subject.
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
•
The Purpose of Tax
Taxing has one basic purpose, which is the fund of the governing body, the price of civilisation. The public sector is funded through tax, and taxes are a major component in the state, local authorities and other public bodies’ funding. Many governments use tax systems for other purposes, resulting from policy considerations. Many economists oppose the use of the tax tools for anything other than its natural purpose - funding the budget. Such objectors argue that achieving these objectives should be implemented through the government expenditure budget.
States use tax mechanisms to affect redistribution of wealth in society, to encourage economic activity and to direct the behaviour of residents, for example, by tax exempting investors in areas, or branches of the economy it wishes to develop, to influence companies to set up factories in industries and areas preferred; the imposition of custom duties on imported goods encourages buying local produce; cancellation of custom duties on vehicle safety aids, for example, increases road safety; increasing tax rates on cigarettes and alcohol encourages reduction in consumption; progressive taxation and granting of allowances and encouraging investment in rent-designated housing construction through tax exemption on income from rental apartments and more.
•
"Normative Tax Structure" and "Tax Expenditures"
As noted, the main role of taxation is funding the state’s budget. For other purposes, the traditional approach prefers their funding through the government expenditure budget, rather than through tax revenues, which are part of the normative tax system. In other words, firstly, the government should collect all tax due to it without any exemptions and only then, it may distribute it in accordance with its operations budget, as approved by the legislature.
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
The tax system, unlike the state’s expenditure budget, is not transparent. Whilst budgets form part of public debate, is known and a subject to controls and the executive branch is not allowed to deviate therefrom, tax benefits are not known or measurable, neither in advance and sometimes, not even in retrospect, it is not accessible and changes thereto require inflexible legislation. There is inherent difficulty in measuring various tax benefits because tax authorities lack tools for measuring benefits granted, not to mention that there are many influential and interested people in this field, who can tempt decision makers to distort the normative tax structure in different ways that are not transparent to the public.
Politicians like tax benefits, called ‘tax expenditures’; they give them power and prestige. This is very convenient, especially since the financial implication of the benefits is not publicised and in many cases is not measured at all. Such tax benefits violate the rules of justice in taxation and should be visible and publicised. The right way is to make them part of the state budget, rather than allowing them to exist through tax benefits. Another way that was proposed is to form a tax expenditure budget, which would be visible to the public.
The tendency in the world is to avoid achieving sub-goals through the tax system, subject to the distinction between ‘tax expenditures’ and ‘normative tax structure’. The normative structure shall include any provision that is consistent with the relevant fundamental principles of theoretical tax structure and of the distribution of the tax burden and imposition, such as the principle of the ability to pay, or the principle of benefit and burden to public services. All other tax purposes shall remain outside the normative tax structure and to the extent that they are included in tax laws, they will be considered as tax expenditures.
Tax expenditure is illegitimate because it is not part of the normative tax structure such as tax benefits for dwarves. The question of what should be included in the normative structure is part of a political debate. Is tax benefit for dwarfs tax expenditure and therefore a part of the state budget, or is it a part of the normative tax structure, which must be examined against the principles of justice and equality. Deeper consideration of the issue will lead to the question of whether fundamental taxing principles require that dwarfs pay less tax, because only then
9
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. will such benefit form part of the normative tax structure, or, if the need that dwarfs pay less tax is a rather moral or social consideration, it should then form part of the state budget.
On the other hand, when a government is unable to provide a public service to a particular population, say as an example, providing an access road to isolated villages, then there is no justification to charge them with full tax rates and it would be justified to grant them an exemption. Thus, such a benefit is both efficient and forms part of the normative tax structure. That would not be the case, where the exemption is granted as part of an ideological consideration, such as an attempt to encourage settlement in those remote villages.
•
Taxing and Justice
Distribution of wealth in society stems from the activities of various individuals, but chance and luck has a major role in the results of this activity, for better or worse. Children born to poor families or in isolated communities do not enjoy an equal opportunity to those who are born to rich families in major cities. Such neglect should be regarded as the failure of the government to fulfil its obligations to those populations. For this reason there is another role that government has, which is the rectification of the distribution of wealth, as a social goal, even at the expense of economic efficiency. One of the government’s functions is to balance between efficiency and equality.
The social groups that support the notion that the purpose of tax is only to fund the budget of the state, seek a narrow government with minimal budget and taxation, whilst leaving the private sector to provide the remaining public services. They say that an ‘invisible hand’ will produce the optimal economic efficiency. On the other hand the perception that government's role is to create distributive justice, requires a broader government and therefore higher taxation to finance its budget. There are no empirical studies that prove the utilitarian arguments, but what is clear from empirical studies is that investment in human and social capital leads to long-term
10
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. economic growth. If so, distributive justice in education becomes more efficient in the long term.
Even utilitarian demand social justice in the name of economic efficiency. The argument is that the greater social justice, the greater solidarity and lesser crime.
Thus will public expenditure be reduced (police, Judges and prison staff) and income from tax will increase, as most tax evaders will start paying taxes.
Consequently tax burden will be reduced and the additional income will be directed to strengthen economic activity. Personal and associated welfare will grow, which will trigger solidarity, which in turn will attract investments, and so on and so forth.
Having determined that the distribution of the burden of tax should be undertaken in a fair manner, whilst observing principles of equality and justice, we must turn to seek those rules, which will stand at the basis of just distribution of the burden.
In seeking such rules, we might, on the one hand, find ourselves diving into the depths of ancient philosophical questions of the essence of justice: distributive, compensatory, material, formal or divine, which take us back to the days of Greek philosophical. On the other hand however, there is concern that we might be drawn to determine rather subjective rules of justice that are not acceptable to everyone.
Not only that, but rules of justice cannot be quantified and therefore rules must be based on principles of equity, which are quantifiable - such as equality and uniqueness. According to the rules of equity we discuss two types of ‘justice’ in taxation: the first is that equal people share the burden of taxing equally and this is the
Horizontal Equity Rule; the other is that different people share the tax burden differently and this is the Vertical Equity Rule. These rules lead to the question of the criteria for determining equality and difference between people.
But in order to achieve equality and distribution of the tax burden, we must realise the purpose of taxing, including its sub-goals, redistribution of wealth in society or the promotion of economic policy, which makes the task more difficult and
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. complex. The question of what is just distribution raises controversy amongst scholars, each according to his/her perception.
Distributive justice is achieved where the distribution of wealth in society corresponds with the criteria of equality. Philosopher John Rawls in his book
‘Theory of Justice’ (1972) describes justice as ‘fairness’. He argues that just appropriate distributive policy should aim at improving the condition of the most poor in society and that inequality in distribution of resources, may only be justified, if it is aimed at achieving that goal. Other philosophers (especially liberals) argue that distribution of resources is just as long as it is not a result of coercion or violence. That is, the distribution was achieved voluntarily. According to philosopher Nozick, a just situation is where it has been achieved as a result of just actions and with no violence.
Another proposed formula, called the ‘capabilities approach’, states that achieving distributive justice requires that everyone will be able to realise itself and that therefore it is necessary to have access to basic resources and opportunities. This approach requires the state to provide the means for the weak that will enable them such access and dignified living conditions. Utilitarian believe that just distribution is one which leads to maximisation of the welfare to most residents. Today there are school of thoughts, according to which distributive justice must be implemented at a global level, against the background of inequality in living standards in developed countries, versus developing countries. The importance of the two types of justice (horizontal and vertical) is reflected in both the moral and practical levels: in horizontal justice, there is a moral aspect of equal treatment of equals and the practical aspect of preventing a feeling of discrimination. Vertical justice too, has a twofold aspect, the moral one, whereby equal tax must not be applied to different people, where more may be collected from those who have and less from those who do not, and the practical aspect of the sense of equality, whereby the ‘pain’ of the rich and that of the poor, resulting from the payment of tax - should be similar.
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
Therefore it is only left to determine what is ‘equal’ and what is ‘different’ and the extent of relevance of the extent of such difference.
If two people are earning 100, but suppose one of them is a dwarf and the other is not, should they pay equal or different tax? In other words, how relevant is the question of dwarfism to the rate of tax? If it is relevant, then this relates to a normative tax structure and if it is not, then a difference in applied rates would be characterised as tax expenditure. What if the dwarf was disabled, would that justify a difference in taxation, based on the vertical justice rule? Are the dwarf’s special needs as a disabled person relevant to the payable tax rate? Is relief in disabled’s taxing a question of equality in taxation, or is it a choice the state makes to assist the disabled, as a social consideration?
•
Distribution of Tax Burden
In the ancient world, it was common to impose ‘poll tax’, which imposed uniform tax on all residents. During time, probably, the vast majority of people were equal in income and financial capability. Such taxing was part of overall taxes, imposed under the laws of the Kingdom (such as customs and land taxes), but also and mainly, by force of the laws of religion (tenth, gather, oversight, edge etc.).
Against this background, the poll tax could be considered fair and equitable. It was considered efficient, simple and most convenient to collect. Today, due to vast difference between people, it is considered unjust.
Attempts to impose such a tax in modern times failed. It was in the 60's, when the government of Margaret Thatcher sought to impose a poll tax on the people of
London in order to save the collapsing municipal purse. That experience prompted substantive street riots and threatened Mrs Thatcher’s administration, which lead eventually to the abandonment of the idea.
Distribution of tax burden connects to questions of justice in taxation, since it deals with the question of the most just and fair method of distributing the burden between residents. Distribution of the burden must take into account both
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. economic efficiency and equality, reflected in the rules of distributive justice. In order to achieve these results, distribution must consider the general diminishing marginal effectiveness of money, out of which stem two principles: the principle of benefit and burden and the principle of the ability to pay.
The principle of diminishing marginal effectiveness of money: the principle holds that the marginal effectiveness produced by a person from his/her income, decreases with each additional unit of money earned. Every person has his/her own personal curve, but we can apply the principle to all. Accordingly, if tax is imposed equally, the rich's pain, derived from the tax imposed on the last unit of money he/she earned would be lesser than the pain of the poor, paying tax for his/ her last unit earned, ergo, in order to match the pain of loss, resulting from the payment of tax, the rich would have to pay more tax than the poor.
The principle of Benefit and Burden: If one undertakes a kind of privatisation of public services and converts tax into a sort of price therefor, then it is appropriate to examine the extent of use thereof by each resident and accordingly, how much should be charged from him/her. Each person should pay a tax, corresponding to the degree of benefit he/she derives from the public services, provided by government. This is such a romantic idea that will be difficult to implement, but quite obviously, the rich will have the benefit of more education, roads, justice system, etc. than the poor would and in other words, the rich consumes more public services than the poor, this is why he has to pay more tax.
The principle of the ability to pay: The principle states that each resident should be charged with the tax he/she is able to pay. This principle draws its essence from the principles of horizontal and vertical justice and is influenced by the questions these principles raise. Public discourse on this principle persists in developed countries and involves the question of what is the relevant difference between people, for determining the capability to pay. Discourse exists less in lesser developed countries and close examination of this definition raises difficult questions, for example:
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
Some argue that tax should be levied by reference to talent, i.e. the capability to produce capability to pay. This is a tool within the boundaries of distributive justice, which seeks to impose greater tax on those who are talented, but do not generate income, than on those, who are less talented, but do work hard to generate income. The tax imposed on both does take into account their respective income, but does not take into account the wasted talent of the first and especially the positive externalisation (the benefit of the entire population) of the fruit of the efforts of the less talented.
Another argument is that tax should be imposed based on the consumption of each individual. Under this approach, consumption should reflect the consumer's capability to pay. However, implementation of this approach introduces nonpayment of tax on savings income, which is not ‘consumed’ according to the formula: I = C + S (I=Income, C=Consumption, S=Saving). In contrast, savings will be consumed at some point in the future, so accordingly, tax thereon would be imposed, albeit later.
Another approach is to impose tax by reference to the increase in wealth, which serves as an indication of the capability to pay. A person may find him/herself in a situation where his/her wealth will have increased, without in fact having an income at all and accordingly, there shall be no basis to impose tax. Increase in wealth may be measured by the following formula: I = W2 - W1 + C, where I
(income) = W2 (wealth at the end of the year) – (minus) W1 (wealth at the beginning of year) + (plus) C (annual consumption).
The limitation of this method is the place of human capital in all of the assets of a person. Avoiding the measuring of human capital would produce a breach of the principle of horizontal justice. This also raises second-tier issues, such as the inability to measure wealth or to measure annual consumption.
All thinkers and scholars believe that tax should be imposed differentially. Even
Nozick, who is a radical in his approach, agrees that there is need to reduce tax levies for those with low capability. His reasoning is that the protection of natural rights is provided by the government to both the rich and poor, albeit the latter
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. enjoys less and would not have paid for such rights, for lack of capability. Since the majority imposes it view on the minority, this requires a process of
‘compensatory justice’.
For practical reasons, states tend to impose tax (and such method is accepted worldwide) only on income, the definition of which varies from one tax system to the other. The questions arising from imposing tax on income are by definition: what is taxed income, how it is measured and what is the date of its tax assessment? There are a number of possible acceptable stages in determining the date on which this income is part of the tax assessment, which are: the point in time of the potential to generate it, its actual production date, the date of sale
(regardless of when cash transactions occur) - accrual basis, or at the time physical cash is actually received or paid out -cash basis, all subject to special provisions of the law, or to generally accepted accounting principles (GAAP).
Illustratively: a man who came to own an oil well, which has great potential for income, when should he be taxed? Clearly, income will be taxed at some point in any case, but the question is when is the correct point to impose tax liability, pursuant to the principles mentioned above: somewhere between the edges of the
‘discovery’ of the oil, upon actual cash payment for the sale or somewhere in between those points.
•
Does tax breaches Fundamental Rights
Taxation in its traditional definition forms taking. The taking of tax can violate proprietary rights, equality, standards of living, freedom of occupation, freedom and privacy and could even depress economic activity. Under these circumstances, the question arises whether taxpayers have the choice of not paying tax imposed.
We all know the phrase, claimed by the Americans during the Boston tax revolt
(known as ‘The Boston Tea Party’) according to which "No Taxation without
Representation".
We have already defined tax as the price for civilization, i.e. a necessary evil, or perhaps this is not the correct definition? Perhaps this is just the price of
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. maintaining a political organisational structure. Accordingly, it is necessary that tax be imposed as part of the social treaty and by an authorised representative, i.e. in law. Accordingly, tax should be viewed as the agreement of the public to fund the state budget, subject to constitutional judicial review.
The impact of taxing on fundamental rights, as seen, may take several forms.
Firstly, if the principle of the ability to pay is not implemented and tax is imposed on income that is insufficient to allow basic existence, it is unfair to put a person in a dilemma of priority of who comes first, the state or the family. Another compromise might be that to the freedom of employment, where one sector enjoys subsidies by form of negative taxing, it follows that other sectors that do not enjoy such suffer damage to their competitiveness. The heart of the discussion is the claim that taxing violates the proprietary right, i.e., whether by its very definition, taxing violates such right.
The answer is unequivocal, which may be seen through the question of the effect of taxing on labour supply. Leisure consumption is a substitute for work; when we consume leisure, we lose working hours. Suppose a person earns 10 per hour of work and the rate of tax imposed on him was raised from 20% to 40%. That person could believe that as long as his/her net income was 8, he preferred to continue working, rather than consuming leisure. But now, that the raising of the tax burden leaves him/her with only 6 net earnings, it is not worth it to continue to work and that it is better to consume leisure rather than work. On the other hand, that person could say that because he earns only six, it is not enough for him and he/she must work more, in order to have enough to be able to consume leisure. In this case the two effects offset one another, but no empirical studies exist, that support this economic theory.
The approach of philosopher Jeremy Bentheim: According to that approach, proprietary rights do not exist in the natural state, but derive from a set of laws, which acknowledges them. Tax is also the creation of law and therefore affects the definition of proprietary rights in a manner that deducts the value of tax therefrom, so that ab initio, it includes the value of that component. In other words, both tax and proprietary rights are the creatures of the same set of laws, without which,
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. neither would exist. Moreover, if proprietary rights are a creation of law and taxation is the creation of the same law, then it follows that proprietary rights will be defined by such law in a more limited way.
The approach of philosopher Jean-Jacques Rousseau: By the very agreement, reflected in the social treaty, residents of the state waive proprietary rights in its favour. Therefore, proprietary rights already presuppose the tax burden and proprietary rights are therefore given lesser standing and are awarded to residents by the state, having already been discounted by the value of tax component.
It is clear that both approaches still require fair and just distribution of proprietary interests by the state, as between it and its subjects, and therefore such distribution must be based upon transparent constitutional rules and be subject to judicial review. The approach of philosopher Robert Nozick: This approach is different from the other approaches. Nozick's view is that all tax violates proprietary rights, but that such injury must be subject to criteria of constitutional rules, which are subject to judicial review. He illustrates this approach by the captivating argument that the imposition of tax on labour forms expropriation of the employee's time and therefore makes him a compulsion labourer. Nozick of course ignores other aspects, relevant hereto, such as the employee's use of public capital to generate income. The partnership approach of philosopher John Locke – "The Labour Theory of
Value": Accumulating property is a process that involves firms, utilising the manufacturing facilities, finance, labour and social capital. Social capital is manifested in infrastructure, the legal system, freedom of contract, education, security, health, foreign relations, economic stability and more. All these are provided by the public through the state and so, there exists a kind of partnership between the state and the firms, where tax is found in the distribution of resulting income. This mechanism must be qualified in that the state indeed receives only its part and does not dip into firms’ share, tax only serving as a mechanism for distribution. 18
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
The cost of access to public services approach: If public services were provided via the free market mechanism, firms were supposed to pay for them. The existence of market failures and of social values, require that the state provides such services. There is no merit in the question of free choice of purchasing services in the private sector, compared with the forced choice imposed upon society, to purchase these services from the state. Even if free choice was available, it would have been a quantitative choice of the extent of consumption, rather than a qualitative choice of whether to consume, since consumption of these services is natural and automatic. Therefore, tax is actually paid for services rendered. The above collected information shows that as long as we elect representatives to serve as legislatures and taxes are imposed by legislated rules, and these rules are subject to constitutional judicial review as to their compatibility to constitutional fundamental principles, i.e., they comply with the definition of ‘good tax’, they do not violate fundamental rights and inasmuch as they do, they shall be revoked by the Constitutional Court.
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Rudiment Principles in The Theory of Tax
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Chapter Two – Postulates
3. Terms
•
Tax Unit
Tax unit is the taxed entity. It can be an individual, a family, partnership, company, etc. and the determination of what is the relevant tax unit for purpose of taxing has far reaching implications.
For demonstration purposes – the taxing of a family can be undertaken in several ways: Taxation of each individual within the family cell, taxation of the unit as a whole or separate taxation for each individual within the cell, by dividing its entire revenue between the couple. Each method will lead to a different result.
•
Positive Tax
Tax paid to the government by all taxpayers. This is the classic structure of tax.
•
Negative Tax
Payments paid to residents by government, such as subsidies, transfer payments and even classic negative tax. Negative tax is an unhealthy phenomena and is a mirror image of positive tax.
•
Direct Tax
This is tax, which is paid by the formal entity which in fact owes it. For instance, an individual or a company pay tax for their income. There are a number of direct taxes, the most known of which is income tax. In addition, there is tax on capital gains, raffle gains, gifts, inheritance and more.
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
•
Indirect Taxing
This tax is characterised by that it forms part of the price of the product or service upon which it is imposed. The formal entity, which is levied with the tax, is the seller of goods, or the service provider, although they are not the ones who fund it by adding its value to the price asked. Examples of indirect taxes are VAT, customs or purchase tax, all allegedly imposed on the seller or provider, but rolled onto their clients, forming part of the price asked for the product or service.
4. Mandatory Payments
•
Definition of Tax
Tax is defined as a sum of money, for which there is no direct equivalent value.
The definition consists of three components, each of which creates its own difficulties: payment, coercion and consideration.
Is it at all possible to impose tax on all citizens, when there is allegedly an option to avoid payment of tax, by avoiding work, which negates the requirement to pay income tax, or by avoiding purchase of products or services, which negates payment of VAT? On the face of it, technically, one cannot force a person to consume and indeed, there are those who do not pay tax everywhere. This is the reason that taxes are imposed where a person works or consumes. The very coercive nature of tax collecting originates in those free riders, who use public services without paying for them. They are similar to those, who take products from a shop without paying for them and in order to ensure that they pay due tax, it is necessary for tax to be mandatory and liable to be collected by force.
Theoretically at least, pursuant to the social treaty, there should be equal-valued consideration for the tax paid (tax efficiency). What form such consideration takes and how may it be measured are difficult issues to quantify.
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Dr. Jack Itzhak Barsheshet, Ph.D.
Within the definition of tax, it is common to include classic tax, positive and negative tax, as well as supports and subsidies, provided by government. In broad terms, tax is the total net of resources that the state receives from the public. The collection of tax and the use thereof is under constant scrutiny, because it involves compulsory depriving of private property in favour of the collector.
•
Price
Payment paid, in consequence of a voluntary act, mostly in the private sector, but not always. It involves voluntary payment for products, or services, consideration for which is usually equal in value and does not include elements of tax. The legal structure does not usually interfere with questions of price, as opposed to issues of tax, with which the system should and is obliged to interfere. We know of essential services, which price includes an element of taxation, such as the price of water, the charge for which may change due to political considerations, rather than economical ones (demand and offer). These are mostly governmental monopolies, upon which the forces of the market have no effect.
•
Fee
Payment, which may either be imposed or chosen, dependent upon its nature, against which there is direct consideration in public service or product, but which is not equal-valued to the fee paid, such as licensing fee. Where no service is rendered, no fee is payable. Whilst direct consideration is involved, it would not necessarily be equal to the fee paid and often it will be higher than the cost element for the service rendered. Charging of fees forms common means of collecting money by government and is its favourite, because it is collected from the public, who perceives it as payment for service rendered.
Fees are a dual vehicle, as it contains both a price component and that of a tax, which for some is a positive tax and for others, a negative. Those who receive services, valued at more than their levied contributions, pay positive tax, whilst those who paid more than the value of the service they received, pay positive tax.
The position is similar, for instance, with social security payments: the same
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. service, purchased on the free market may be charged differently than by the state, which in fact makes such contributions a kind of a fee, and so those who pay high amounts and receive less valued services, pay positive tax, whilst those, who pay less than the priced value of the services they receive, pay a negative tax component. There are also the ‘sophisticated’ fees, such as lotteries, which is a problematic creature in the sense that it does not involve forced payment, but does involve direct consideration, of unequal value in essence. Accordingly, payment for lotteries is similar to tax, used by the government to fund welfare. In fact the use of lottery funds contributes to the widening of financial gaps in society, since most buyers of lottery tickets are of the lower classes, whilst the fruit of the financial investments in lotteries, often benefits mostly the higher ones. Another difficulty is that the division is not going through a democratic process and may therefore be unequal. •
Participation Fee
This is a payment of an amount, levied upon a person which receives a certain service given to him/her by a governmental body. The payment should be relatively equal to the cost of the service. The idea behind participation fee is matching the cost of the service and should not include any hidden tax element, aimed at enriching the entity that imposed it.
•
Municipal (Propriety) Tax
Municipal (Propriety) taxes are commonly calculated against criteria referencing the size of the property held by taxpayers, the value and the number of residents therein. Its purpose is to fund the services provided by the local authority, such as roads, infrastructure, landscaping, social activities and more.
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Dr. Jack Itzhak Barsheshet, Ph.D.
5. Differentiating between sorts of Mandatory Payments
•
The Tests for Differentiation o Where payment is made for service rendered and it is relative in its amount to the value of the service, it is then a price, rather than tax; o Where the amount payable is greater than the value of the service, but there is a link between the service and payment, it is then a fee and not tax; o Where payment is levied upon a certain type of activity, rather than in general, it is a projection or participation fee but not tax; o In all other cases: where there is no link between payment and particular service, or where the basis for payment does not originates from the payer and it is imposed by coercion, it is tax.
•
The Significance of Differentiation
We have already seen that tax may only be imposed by the House of
Representatives, as representative of the people. However, the House of
Representatives may delegate certain powers to other government units, such as municipalities. Accordingly, it may be said that at one side of the scale there is tax, which must be legislated by the House of Representatives, whilst on the other side thereof, is price, which does not require legislation at all. Within those brackets, exist various payments, which form both price and tax and those, having included in them an element of tax, require the government units to be authorized by the House of Representatives before they may be imposed. It is clear that such payments too, are subject to constitutional review.
6. Public Goods
Public goods are defined as goods, supplied by the government, and which has two qualities:
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Dr. Jack Itzhak Barsheshet, Ph.D.
1) Consumption of such product by one individual does not compromise or reduces the consumption thereof by another individual;
2) No individual may be prevented from consuming the product. For instance, security (a public good of the greatest demand), environmental protection etc. the service provider is the government and payment for the service is collected by taxing. The provision of such services must be undertaken by the government, rather than by the market, because of the existence of market failures.
This is similar to the use of a lighthouse, which everybody may use without fear of compromising others’ ability to use it and which use by another, no one can prevent.
7. Market Failures
This is a term that describes a situation where the market is inefficient in providing a service or product. Market forces do not allocate resources to provide the service or product, because they cannot efficiently do so. Alternatively the term describes a situation where market price does not reflect adequately the costs of production.
By their very essence, public goods invite inherent market failures, where aimed to be provided by the open market. The classic assumption, according to which market forces alone, where sophisticated competition is present, bring the market to an ideal place, will not apply to those products.
Examples for market failures are:
A general market failure known as ‘free riders’: This is a market failure in which some people, seemingly, prefer to forego their need for public goods and avoid revealing their related preferences, because they know that the market will provide
25
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. such products in any event and that they will be able to enjoy them without paying for them.
Another market failure is called ‘adverse selection’, according to which, provision of certain services by the private sector, will cause it very self to collapse. This is illustrated by reference to the health insurance market, where asymmetry between information, held by insurers, compared with information, held by insured may be found. Where residents are willing to purchase health insurance, those who are at high risk will be more likely to purchase insurance than those with low risk, which will result in insurance rates increasing, to the effect that those with low risk avoid purchasing insurance all together, which in turn, triggers a further rise in premiums, with the effect that those at high risk won’t be able to afford cover either, which will then trigger the collapse of the market. Another example of market failure in a condition of asymmetry is the used car market. In this market, buyers hold incomplete information, compared with sellers. As a result, this necessitates the buyers to assume that cars are of generally poor condition, which triggers a generally lower sale price achieved, than would have been the case in a more sophisticated market.
Another market failure, which involves external influences thereon, is known as
‘externalities’ failure. This involves services or products, which effect extends beyond the personal and direct interest of the service provider or receiver, or the seller or purchaser of the products. At times this involves negative externalizations, such as air pollution, the by-product of the pharmaceutical industry, and at times it involves positive externalizations, such as improvement in the quality of air, associated with oxygen emission, triggered by planting of various plantations.
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Dr. Jack Itzhak Barsheshet, Ph.D.
Another market failure is the ‘moral hazard’, which involves a situation where one may consume products and services, at a lower price than their real actual or perceived value. The average consumer is likely then to consume more than he/she really needs, while he/she is not the one to bear the responsibility to any risk that could emerge from it. For example, when a company ensures itself against theft, the company will make low investment in security. Therefore, the moral hazard causes a distortion in the economic investment of resources and to overvalued services.
An example of market failure in the public service is education: if education was provided by the free market, the recipient thereof would have only seen his own education as an interest and would not have noticed the benefits of education to society as a whole, for which he would also be unlikely to agree to pay voluntarily. The result is that the demand for education will be that education will be offered at a lower price than its real value, which is the total benefit of the personal and general. Beyond that, other, second-tier questions also arise, such as questions of distributive justice, because where education is provided by the private sector, it is likely to be provided differently to the rich and the poor. In addition thereto, this introduces more questions, such as which ‘education’ should be encouraged and funded - whether education in social sciences, engineering, music or perhaps religious studies?
On the other hand, there is also the matter of the converting of public goods with normal ones. Since financially strong groups fund weaker groups, who do not participate in lifting the tax burden, they prefer to incentivise government to provide higher quality and therefore more costly public goods, which is manifested in toll roads or private medical services, which has the effect of reducing the number of available public goods, compared with normal ones.
The more a public good is critical for society, the more there will be tendency to fund it by the relevant funding sector, such as with security for instance. However, the less critical the product, so will the tendency to fund it privately increases, in
27
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. order to secure a better product at a lower price, which is the result of the market failure of externalization.
8. Incidence of Tax
We have made reference to the distinction between direct and indirect tax, but a distinction based upon these definitions is problematic. Pursuant thereto, any tax may be defined as direct or indirect, for example, where an employee agreed with his employer on net figure in wages, the employer shall carry the burden of tax, which will make it an indirect one, whereas where a gross amount was agreed, tax would have been a direct one. This is also the case where an order is made for a price, which is inclusive of VAT. In this example, the seller will bear the burden of tax and not the buyer. It follows then that the nature of the relevant relationships, the flexibility in supply or demand and the relative strength as between the parties are all influential in determining whether the tax, imposed in any given case is a direct or an indirect one.
There is another ambiguity in this division, for defining direct tax as one, imposed on income and indirect tax as one, imposed on expenditure, blurs the distinction between them, since it is not always clear what is income and what is expenditure and determination sometimes depends on perspective. Therefore it would be better to define maters in the following way: taxation will be direct whenever the assessed tax unit and the taxpayer are one and the same, and is considered indirect when the two may be distinct, for instance, where in a purchase of a product, the consumer in effect fund the VAT, but the liability to pay it to the authority, rests with the seller.
Also, direct tax varies according to personal characteristics, such as income, age, marital status or health, etc., whilst indirect tax does not factor in distinctions between various types of people. Thus the rich and the poor pay the same indirect tax rates, which is attempted to be levelled out, by applying different types of tax to different products, for example, by implementing tax exemptions on basic food
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. and products. Socialist countries will naturally prefer direct taxing, whilst capitalist ones will prefer indirect taxing, on the grounds that it is more equitable, effective, easy, and inexpensive to collect.
It is common to refer to the differences between these two approaches and to politically define them, in the economic sense, as left and right. Tax laws often reflect governments’ views on the political, economic and social issues. Political platforms include explicit reference to tax - social or capitalist, encouragement of traditional or innovative industries, support of different sectors and more.
Discussions over social and economic policy involve reference to those who actually carry the burden of the incidence of tax, i.e., not those who pay it in practice. However, questions of the interpretation of law involve the payment of tax in practice. The central question in tax law is upon whom tax should be imposed. The actual payer will the one who bears the responsibility to pay it, which is the one who will always be taxed in practice and against which enforcement action will be directed. Notably, the theoretical starting point of the incidence of tax is that the burden to pay tax do not lies with the formal bearer of the tax, therefore we should deal with the one who bears the burden of the tax and not the one who bears the responsibility to pay it to the treasury.
We further emphasise the theoretical/economical debate which is focussing on the carrier of the burden of tax, whereas the legal debate involves the taxpayer, and this creates an apparent dissonance between them.
Difficulties arising from the Incidence of Tax
The discussion on the question of who bears the tax burden is problematic since in some alternatives we`ll find one who bears the tax burden and in another alternatives we`ll find another who bears the tax burden. It follows that the character of the one who bears the tax burden varies depending on the circumstances. We will demonstrate it with an example:
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Dr. Jack Itzhak Barsheshet, Ph.D.
Tax laws impose a tax for corporate profits, separately from the taxing of its owner. Accordingly, where corporations distribute dividends, additional tax is imposed on its shareholders. Imposing harsher burdens on companies does not constitute a problem, because it assumes that those who shall absorb the burden will be the shareholders. The Company may transfer the burden by reducing wages or increasing prices with the effect of preventing the shareholders from such burden, which will thus be partially or entirely transferred to the company’s creditors, customers, employees and others.
This issue is also relevant to discussions on tax benefits - such as tax benefit for those who live in areas of national priority, aimed at incentivising people to move there. In this case, the employee is the one to benefit from the tax benefit. If we assume that in this geographical area there is a low demand in employees along to large employees supply, the wage will also be low in this area. In this case, since the cost of the wage to the employer includes the wages and the tax, then the employees will get low net wage (which contains the cost of the wage of the employees without the tax) and an even lower gross wage (as a result of the tax benefit). The outcome of this situation is that the actual beneficiary is the employer. Accordingly, against all existing arguments with regards to tax incidence, it may argued that parts of it thereof, in practice, is rolled over to other entities, so that the question of tax incidence relates to any discussion, related to tax policies, transforming it to an empiric one, ultimately determined by market forces.
The following is a fascinating example from the field of VAT: in the State of
Israel, when VAT rate increased from 17% to 18%, 2/3 thereof was imposed on the consumer and 1/3 was absorbed by sellers. In contrast, when VAT rates increased by 0.5%, no change in prices occurred and when VAT rates dropped from 18% to 17%, consumers enjoyed only a decrease of 1/3, meaning that sellers took the remaining 2/3 into their own pockets. Accordingly, it would not be utterly accurate to say that the entire burden, associated with VAT, rests solely with consumers, who are the formal bearers of responsibility to fund it, as it may be seen that when VAT rates change, the burden may not be wholly borne by
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. consumers, but rather it is shared in part by parts of the production chain, i.e., it does not roll in full.
9. Principals of a Good Tax system
In his book ‘An inquiry into the Nature and Causes of the Wealth of Nations’ (‘the
Wealth of Nations’, 1776), Philosopher Adam Smith references four principles, required to be present in a tax system, so that it may be regarded as a good one.
These are the golden rules of public policy on taxing:
i.
ii.
Certainty;
iii.
Convenient;
iv.
i.
Basic fairness;
Practicality.
Basic fairness: Taxpayers must be taken into account in the imposition of tax, which must equally be just and fair. This general statement embodies all fundamental principles of justice and equality. It demonstrates that the personal circumstances of each individual taxpayer must be taken into account and that his/her fundamental rights, such as the right to dignified existence, may not be breached by the imposition of tax. Accordingly, the tax system must leave taxpayers and their families with sufficient financial resources, necessary for dignified existence and tax may only be imposed on income, exceeding such threshold. There are those who widen that scope in arguing that tax must not be imposed on amounts, which do not exceed the amount, required for the taxpayer’s intended consumption, which is subject to his/her own discretion (discretionary power to consume). A further argument, derived from the rules of justice, is that taxing would not be imposed for unmaterialised wealth, as this might create a situation where a taxpayer is liable to pay tax for property, which increased in value, where he/she does not have the liquidity to cover such tax, which might force him/her to dispose of other
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. property, just to meet the tax imposition. Such a situation, forms a severe compromise of proprietary rights. ii. Certainty: Tax should be certain and predictable. Tax must be collected in accordance with rules, which are clear and known in advance and not arbitrarily. We have already noted that tax is imposed by force of a social consent and thus, tax levied retroactively may not be subject to agreement, and so it should be known in advance. Retroactive tax legislation is also unjust because people determine their actions with reference to existing tax provisions, and would have perhaps conducted them differently, had they been aware of legislation, potentially affecting their position. This compromises the all-important certainty in business, where tax considerations form a substantive factor in measuring profitability.
Social consent and the requirement for certainty also command that tax legislation be simple and clear. Complex tax laws require interpretation, which by its nature, will differ from person to person and might create discrimination between otherwise equal taxpayers. The demand for simplification of tax rules is not easy to comply with, since tax rules are complex and include legal, financial and accountancy provisions. They are also based on the rapid response to the rapid change of economic activities in the open market. The demand for certainty also relates to another element, which is that tax must not be imposed on income, the realisation, and the extent of which are yet to be determined at the time of imposition. This is yet another reason why states refrain from imposing tax on the increase in value of assets, yet to be realised.
iii.
Convenient: The tax has to be convenient to the tax payer. The practical explanation of this directive is that tax should be close to the ability to pay, both in terms of the amount of tax and in terms of the timing of the imposition of the tax. Tax should be based on fair principles and be close to taxpayers’ ability to pay. Tax must be imposed in a manner that is least offensive to the taxpayer and is just and equal. This requirement and the basis to its implementation triggered extensive writing, which discusses the
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. measure of equality, fairness and justice. It seems agreed by all that the most just measure for fairness in tax systems is that of equality and difference between taxpayers, which requires the development of a measure for the determination thereof.
Since we are discussing economic issues, the correct standards must be those involving financial capability. However, this measure does not reflect the purpose of tax, funding public services, according to which, the right standard should reference the entitlement to public services. It seems that there is a contradiction between these measures, but apparently, they seem to produce similar outcomes, since those with lesser financial capability seem to consume less public service than those of the stronger group. iv. Practicality: Tax must be effective. Simply, the efficiency requirement commands that the cost of the tax mechanism must be low. It cannot be that the cost of tax collection will cost the state more than the revenue taxation generates. This will be a waste of time of the collectors and taxpayers alike.
However, this is a rather simplistic interpretation of this requirement, which is more profound and complex, because efficiency must be examined by tools, taken from theories of public finance and economics.
Effectiveness means that taxing achieves strengthened welfare in general.
However, this stands in contrast of the proven claim that the imposition of any tax creates distortion and change behaviours and therefore necessarily reduces net welfare. Accordingly, this requirement commands that the overall extent of public services provided, must be greater than the injury to general welfare, caused by the imposition of tax. There are however no indicators that can provide data to examine this measure. Some say that perhaps the correct test of efficacy should not be applied to all society, but should rather refer to parts thereof separately. This is because it is possible that certain type of population does not enjoy certain services, which are provided to other portion of society. This requires examination of the rule against such part separately. This raises a fascinating question: whether such part of the population has the right to refuse payment of taxes, paid by other populations.
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Dr. Jack Itzhak Barsheshet, Ph.D.
Some say that in order to measure efficacy, examination must be undertaken of the cost of obedience, such as the cost of book keeping, accountancy, legal advice etc. and also, that tax must not exceed the point, which might encourage taxpayers to evade true tax reporting.
Further Requirements of Good Tax: over the years, further requirements were added to good taxing, which included compliance with constitutional criteria, neutrality in taxing, adaption of the tax system to changes in society and the economy and the use of the tax system in promoting fiscal and monetary policies.
Many states authorise the courts to determine what constitutes good taxing through case law, in the main, in connection with possible injury to constitutional rights, such as: the right to equality, freedom of occupation, the right to proprietary, free choice etc.
10. Neutrality in Taxing
A fundamental principle of tax law is that tax should be neutral to economic processes and to free choice. Free choice leads to fulfilment of personal preferences and this promotes happiness and well-being, and through the
‘invisible hand’ this also promotes aggregated welfare. Tax intervention distorts free choice and thus reduces wellbeing. For that reason, taxing must remain neutral by not causing a change in behaviour. We have however seen that taxing has other purposes, such as ensuring distributive justice, and whilst the two seem to contradict each other, society still prefers distributive justice over efficiency and we will welcome legislation, promoting that cause.
Tax, lacking in neutrality, affects the markets, in that it affects the supply and demand, which in turn injures the efficient allocation of resources in the market because it creates preferences thereto, which are external to supply and demand.
Therefore some stress that neutrality, in the business context, also serves to ensure that business transactions could be undertaken independently, very much as they
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. would have, if no tax was imposed. If the tax system makes it necessary to undertake the transaction in a serpentine way, in order to save tax, then it is not neutral. For example, if taxing of dividends exceeds tax imposed on interest, business owners would prefer to invest in their business, through financial investments - providing the business with a loan or a bond, rather than with a capital investment in capital stock. Consider, for example, a tax system, which imposes tax on inter-corporation dividends. Where a business opportunity arises, which the company planned on funding by use of dividends paid by its subsidiary, pursuant to such taxation, it will surely choose to fund the opportunity by way of a loan, taken from that subsidiary.
The importance of this principle is that healthy economy, present in a developed market, cannot afford a situation where economic processes delay, withdrawn or even transferred to other markets, due to tax considerations.
11. Effective Tax
In discussing taxation, our interest focuses on the tax actually collected, i.e. the effective tax, collected after all market effects and tax planning, which are not part of normative tax structure. Formal (gross) tax is less of an interest to the authorities, although it does have high significance, since the difference between formal and effective tax is the product of implementation of goals that are not inherent to the tax system.
The larger the difference the higher the collection costs will be and the lesser transparency will be. Therefore, common is the argument that in democratic countries, the difference should be low, in order to promote principles of transparency. There should be minimum promotion of goals, which do not serve to fund governmental budget through tax mechanisms. Taxation should be used only where it is clear that the tax system will maximise the generated benefit, although it is clear that in cases in which the state takes with one hand and gives
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. back with the other, there are seemingly unnecessary expenses. We have already said that the use of the tax system to achieve goals that are not inherent to the tax system, introduces a disadvantage of lack of transparency in the distribution of funds, because those are not subject to annual debate and there is no information on the extent of the budget, stemming from such benefits.
12. Efficiency of the Method of Taxing
In examining tax policies, we consider whether the tax system is at an ‘optimal taxation’ level, a concept taken from the theory of public funding. We seek to examine to what extent does the tax system harm economic efficiency and reduces aggregated wellbeing. Another issue, which relates to efficiency is to what extent may tax rates be increased, or decreased and still achieve maximum collection of tax, i.e., what is the optimal tax rate.
The Laffer Curve provides an illustration:
If we impose tax at 0%, then the state will not collect any amount of tax. However, if we impose a 100% tax rate, the state will not collect any tax either, because no one
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. will work. Between these two extremes is an optimal point. On its left, are tax rates lower thereof, which trigger lower collection; surprisingly however, to its right are tax rates higher thereof, but which too, trigger lower collections. It follows then that tax rates, lower than the optimal point, are ineffective and that tax rates higher thereof, are not only ineffective, but are also unjust. The precision of above curve attracted significant criticism, arguing that it's accurate only at its edges, whilst the centre of which is completely random. As indicated, there is no empiric data to confirm or refute the curve or the criticism thereof.
Of course, the political debate between the economic right and left centres around the optimal tax rate. The right wishes to set it to the far left as possible, whilst the left would wish to set it to the far right as possible.
Historical rates of VAT imposed in the State of Israel can present an interesting phenomenon. At first, very moderate rates were imposed, but this tax became to be preferred by the government and rates have been increased time and time again.
However, when the rate was increased from 17% to 18%, there was a decrease in collection. Is it possible to conclude from this that the optimal point of the VAT rate in Israel is 17% or was the decrease in collection due to the economic crisis, in which
Israel was in those years? Once again, there is no unequivocal answer to the question of optimal tax.
13. The Search for a ‘Just’ Tax
•
Progressive Tax
Is a tax system by which the larger the income, the higher the tax rate. Tax is calculated by reference to tables, called ‘tax brackets’.
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Dr. Jack Itzhak Barsheshet, Ph.D.
For instance:
Income
To
Rate
Tax
Accumulated
from
0
Total
Tax (%)
10,000
10%
1,000
1,000
10%
10,001
20,000
20%
2,000
3,000
15%
20,001
30,000
30%
3,000
6,000
20%
30,001
40,000
40%
4,000
10,000
25%
40,001
50,000
50% (*)
5,000
15,000
30%
50,001
60,000
50%
5,000
20,000
33.33%
60,000
70,000
50%
5,000
25,000
35.7%
(*) above 40,001, the marginal rate of tax is 50%.
Tax brackets are inflexible and apply tax from zero income and therefore clearly contradict the principles of justice. This difficulty is resolved by applying tax credits and tax deductions, as shall be seen below.
Some argue that progressive taxation does not really exist because of the principle of diminishing marginal utility of money and that there is a need to compare the sacrifices, made by payment of tax in each bracket. Those who earn little, pay little too, but their sacrifice is however larger. Those who earn much more, whilst paying greater tax, sacrifice less. The more similar the two sacrifices are, the more equitable
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. the tax rate be considered. With the application of the rules of justice, we are likely to discover that this is actually a relative, rather than progressive taxation. Taxation is proportional to the sacrifice, rather than to income. This achieves effectiveness in the redistribution of wealth in society through the tax mechanism. It is in fact a process of reducing social disparities, rather than one of redistribution of wealth.
There is an argument, by which it is possible to impose relative tax and then balance the outcome by redistribution, through the government's expenditure budget.
However, as we have already noted, redistribution government’s budget in fact forms negative taxing and therefore, there will be no real validity to that chosen method.
However, the power of the government to affect just distribution is weakening, because there are public goods, the consumption of which is regressive, for example, the Homeland Security and the Legal systems, which are available to all, but are being utilised more by the wealthier.
For that reason, it is difficult to replace the role of tax in redistribution through the expenditure budget. The main problem in the question of just distribution involves circumstances in which the poor are so poor, that they do not pay tax at all, which makes it impossible to assist them through the tax system, opposed to via the expenditure budget. In contrast, it is possible to utilise negative taxing to assist the poor. •
Regressive Tax
This is a tax, possessing opposite characteristics to those of progressive tax, i.e., the larger the income becomes, the lesser the tax rate imposed. It is an unjust tax, which offends the poor and that is not common.
•
Flat Tax
Flat tax is a tax that does not depend on the ability of the taxpayer (practically measured by income) and according to which, the rich and the poor pay equally. For
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. example, VAT is a kind of flat tax, as it involves payment of a flat tax rate for all members of society.
Many see neutral taxation as regressive tax de facto. The poor consume their entire income and so, tax is imposed on their full income. In contrast, the rich only consume a part of their income and therefore pay tax only on that part, which they consume. If we compare, for example, two people - one who earns 1,100 and consumes all of it, and another, who earns 100,000 and consumes only 22,000 thereof. Assuming the tax rate of such indirect tax is 10%, we shall find that the poor pays 9% of his income as tax (100/1,100), whilst the rich pays only 2% (2,000 / 100,000) of his income. Since saving is defined as future consumption, eventually all the income of the rich will be directed to consumption.
There are advanced studies, seeking to examine tax neutrality as fixed percentage of income, rather than as fixed amount or in reflection of the principle of diminishing marginal value of money, i.e., determination of the neutrality of tax by reference to income, rather than to circumstances.
•
Tax Credits and Tax Deductions
As mentioned, the tax brackets are rigid in the sense that they apply to all populations without exception, even to those with zero income. In order to ease this inflexible rules, without compromising basic tax rules, it is possible to apply rules, introducing adjustment of tax brackets to different populations, at the stage after due tax was calculated. For instance, adjustments may be allowed by reference to family size or by setting a minimal threshold, which ensures basic existence etc. Such flexing of actual tax payment to be levied is achieved through tax credits and tax deductions.
Tax Credit: is the rate of reduction in the amount of tax due from a taxpayer, pursuant to the provisions of law and tax brackets. For instance, where the state grants annual tax credit in the amount of 1,000 to dwarfs (or students), a dwarf, who earns
20,000 annually, and who should have paid 3,000, pursuant to the above table of progressive taxation, will only pay 2,000, due to such credit, granted to dwarfs.
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Tax deductions: involves the reduction of the taxable amount of income. For example, pursuant to a tax deduction in the amount of 10,000, the dwarf, referred to above, will only pay tax on income of 10,000, i.e., only 1,000. Therefore despite tax imposition starting from zero income tax deduction provides the taxpayer a basic taxfree income.
Tax credits and deductions are part of the normative tax system, as long as they are granted for the promotion of normative tax principles. For example, if the government wants to encourage, through the tax system, the bringing of babies into the world, by introducing tax credit or deduction, then as long as the credits or deductions are aimed at enforcing one of taxing’s fundamental principles, such as the one involving ability to pay, the adjustments will be regarded as part of the normative system, whilst any adjustment, which exceeds this range, will be considered as outside the scope of the tax expenditure (deductible expenses).
Regressive credit and deduction: The deduction provides a benefit, reflected in an amount of tax, which increases as income does. If we compare two dwarfs, one earning 20,000 and the other 100,000 and grant both a deduction of 10,000, we shall see that the benefit to the first dwarf would stand at 2,000, whilst the benefit to the second would stand at 5,000. In contrast, credit is somewhat similar to negative personal taxing and is therefore regressive in nature, in that it is granted to all, regardless of levels of income, thereby violate vertical balancing. If we give a credit of 1,000, granted to both dwarfs, it would mean a benefit in that amount to both, regardless of the difference in their income, which forms a violation of the horizontal balancing principle.
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Pigovian Tax
Pigovian Tax is named after the British economist Arthur Cecil Pigou and is aimed at dealing with the negative externalisation phenomenon, created when the benefit derived by one from a service or product, negatively affects his/her own consumption
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An example of such negative effect is where damage is caused by smoke, emitted from a factory pollutes its surrounding environment, or where a factory disposes of its waste in a river, lake or sea, causing their contamination.
Examples of Pigovian taxes are: taxes on fuel, cigarettes, alcohol, vehicles, etc. with all of which, neither the manufacturer nor consumer pay the price for the environmental nor the personal damage caused by use of these offending products.
Pigovian tax increases the cost of the product to reflect the price society will pay in consequence, which may take the form of air purification costs or the price of any other process society is willing to pay to ensure the repair of the damage, as well as the cost of developing an unnecessary health infrastructure for health care system to treat those who suffered direct injury thereby.
This is a market failure dealt with by the introduction of Pigovian taxes, aimed at achieving two objectives: the first is to make the product more expensive and by that to deter consumers from purchasing it, and the other is to raise the necessary funding, required to repair the damage caused to the public in general thereby. Hence, these taxes must, allegedly, go towards funding public transportation improvements, measures to reduce air pollution and road traffic congestion, health, research foundations, addiction treatments and so forth.
The difficulty with Pigovian taxation lies with the ways of determination of the extent of tax that should be imposed and its distribution and in general - if one cannot measure those factors, then it is not right to impose it prima facia. What is the exact amount that one must repay society for causing damage to the environment? It follows that in dealing with the question of the relationship between efficiency and fairness, efficiency prevails and taxes are imposed nevertheless. In this regard, interesting questions arise, such ones, related to customs on cars. Is it correct to say that when a car is stolen, the tax paid for it is stolen as well, or perhaps it is right that the state reimburses the car owner for the tax paid in lieu of the stolen car, because its
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14. Deferral
Deferral forms tax benefit that may be granted through early application of deductible-tax-expenses (such
as
increased
deducible
depreciation)
or
postponement of income. This forms a tax advantage in that it defers the date upon which tax is imposed, although it does not eliminate it altogether. This is the source of the phrase ‘tax deferred is tax saved’. Where for instance, if payment of tax is deferred, say, for three years, where interest rate stands at 10%, those who deferred payment of tax will ultimately pay a total of 66% thereof and in other words, will have saved one third of the original liability. This is due to the price of money, reflected in the rate of interest. Thus, this concerns the present value of the amount of tax deferred, which serves as a discount in the amount of deferred tax liability. Calculating the difference between present value of the deferred tax and tax capital deferred reflects the tax benefit generated by the deferral.
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Chapter Three – Topics
15. Value Added Tax (VAT)
•
Introduction
VAT is a relatively young tax system. It was ‘invented’ in Germany after World
War I. It is a tax, convenient to collect and difficult to evade and is multi-levelled, in that it is imposed on the added value that businesses create. Technically and simplistically, businesses pay VAT on income, minus expenses, excluding the cost of labour. The deduction in VAT is undertaken, based on a document, produced by suppliers and at the end of the tax chain it is rolled into the pocket of the end-non business-consumer.
In most countries VAT is imposed in addition to income tax and in many, higher
VAT is collected, than income tax. The reason for this is the effectiveness of collection thereof, which stands at over 90% of its potential. Despite this, the world did not withdraw income tax in favour of VAT, because it is a regressive tax, for which the state compensates by using progressive income tax.
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Added Value
The economy distinguishes between firms (corporations and non-incorporated businesses) and individuals, the income of whom may take the form of profits, generated by the firms, or of salaries paid by the firms. The added value of the firms is their contribution to gross national product (G.N.P.). One of the definitions of national income is any added value, produced by all firms in the economy and the wages they pay. Therefore it is possible to determine approximately, that the added value is the total of profits and wages paid.
For reasons of simplicity and convenience we include in the total value, added by the firms, the value of the wages paid by them. Since thus, salaries form part of overall value added in the economy, ostensibly, employee should be required to
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VAT may be imposed on the basis of the destination of the goods sold, which means it will be imposed on consumption at the geographical location in which the goods are consumed. Therefore exported goods would not attract taxing, which will be triggered nevertheless on imported goods, which in fact forms tax on consumption, rather than value added tax. Conversely tax can be levied on the basis of the origin of the goods, such tax applied to exports and not on imports, which is indeed VAT, but this however is impractical to enforce, because it involves the taxing of foreign entities, rather than of those, subject to the authority of the state. Therefore naturally and for enforcement reasons, countries impose the territorial tax levied on consumption.
Accordingly, it is notable that such tax is imposed on consumption and not on added value in effect.
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Methods of Imposing VAT
There are different ways to impose VAT. And the following are but a few:
Imposing tax on the first link in the chain: by this option, higher tax may be imposed on the first link in the chain alone, manufacturers or the importers, at an extent, which generates similar amount to those, collected through VAT. This method is convenient, because it involves a smaller number of taxpayers and collection may be secured earlier in the process than otherwise. In contrast, this may deter manufacturers, must already deal with very high initial funding costs, which might in turn highlight to those manufacturers, the advantages of importation over domestic production, which will serve to restrict local growth, as well as an incentive to evade tax.
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A single-stage tax on consumption can also be imposed, which means taxing products’ retail price and in other words, imposing a sales tax. Countries, which impose sales tax, exempt therefrom trade and services activity undertaken between firms by applying a zero tax rate thereto, since tax is already off set within the taxing chain. This method is an express sales tax, although the result it generates is the same to the one, generated by the classic VAT system. The difference between the two methods is that with VAT, the burden is divided throughout the whole manufacturing chain, which also means that collection thereof takes place earlier in the process, because taxing occurs before the final consumer-sale point. However, taxing of consumption imposes a heavy burden on a small group of retail firms and thus creates an incentive to evade tax. It is also arguable that sales tax is levied on turnovers, regardless of the actual generation of profit, or the lack thereof.
Multi-stage sales tax: this involves imposition of a low rate of tax on each stage without allowing the deduction of tax paid by firms, so that in aggregate, the state collects the same amount of tax. The drawback to this method is twofold: firstly it is a tax imposed arbitrarily, without reference to added value. Theoretically, it is possible that a firm is levied with tax, which in itself exceeds the firm’s added value in its entirety; secondly, adding a new factor to the tax chain will cause different taxing on different products, simply by reason of the mere number of firms in the chain. This is an unjust, un-neutral and ineffective tax, because it might cause firms to attempt to reduce the number of stages and inevitably will not encourage specialities, which is the lifeblood of modern technological progress. •
Further Problems with VAT
Modern economic concepts see this tax as a fiscal tool, since it affects consumption. Raising tax rates reduces consumption and might curb inflation. On the other hand, lowering tax rates leads to increase in consumption, and thus, to economic growth.
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The VAT system is simple and uniform, and as a result it does not raise substantial theoretical questions such as justice, redistribution, etc. There are countries in which multi-stage VAT is imposed, or where exemption is granted on certain types of goods, such as medicines, children's clothing, bread, and so on.
Un-uniform tax rates increase the costs of the administration of its collection and cause distortions in the classification of products. Producers and marketers will attempt to classify the products they sell as exempt from VAT, thereby reducing tax liability. For example, questions will be raised of what is medication, what includes children clothing or what is bread.
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Battling VAT Evasion
The temptation to evade VAT is essentially found in the last link in the chain, the one which is contact with the final consumer. It occurs mainly with retailers, coming in contact with the consumer, who cannot deduct the tax paid, but not only that; VAT in its classic form operates in a way that each link in the chain, issues a special certificate to the buyer, which serves as kind of a financial cheque that allows the buyer to reduce the amount of tax it pays, by the amount of VAT, reflected in that document. Temptation to ‘purchase’ such certificates or forge them is substantial and tax authorities are fighting that disease.
There are various methods to combat this disease. There are countries that issue
VAT certificate for the firms, so that tax authorities can keep track of documents and ensure that the firm, deducting tax, stands opposite the actual person who has paid it. There are countries that require firms to issue a VAT certificate before actually providing the goods and a copy of the certificate is required to be delivered in real-time internet communication to the tax authorities. Another method is the transmitting online current lists of all certificates of income and expenditure, which are accompanied with periodic reporting to the tax authorities.
Tax IT systems can compare documents, provided by all firms online and identify
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Tax Regressivity
Value added tax at a flat rate on consumption is regressive in nature because the percentage of income, spent on consumption decreases, the higher the income and the percentage of tax increases, the smaller the income. In order to reduce regressivity, some countries have set different tax rates for different goods, mainly reducing tax rates, even to fully exempting basic necessities, such as medicines, and even children's clothing. These products are consumed mainly by financially vulnerable populations.
Since VAT is a regressive tax and income tax is a progressive one, the two offset, but only to form relative taxing. We have already seen that taxation is relative to income, operated pursuant to the principle of diminishing value of money is a regressive tax. Therefore income tax has to be progressive twice: firstly to undertake the redistribution of wealth and secondly to cancel out the regressivity of VAT. But this would not suffice to provide relief to the poor, who do not reach the stage of triggering tax liability.
In federal states, the particular problem of imposing state level taxes, as well as federal tax arise. When it comes to the distribution of VAT collected between the state and the federal government, it is difficult to determine entitlements accurately. Division must be determined politically and by agreement. In
Germany for instance, the matter was resolved by agreement, but in the USA, no agreement has been reached and thus, each state applies its own rules. The result was the imposition of sales tax (rather than consumption tax) in most, but not all states. Sales tax is simply and is imposed at the place the product was purchased, rather than where it was consumed.
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•
Tax Exemption as opposed to Zero Tax Rate
Countries can encourage or lower the burden of tax for populations or areas by
VAT exemption. This method of relief may be undertaken in two ways:
In imposing a zero tax rate, tax was imposed, but the rate of which is zero. This means that firms will be allowed to deduct the tax they pay to suppliers, but will pay zero tax on their income. The significance in applying this method is in that it lowers the full burden of the tax entirely for the benefit of the entire chain.
Tax exemption is another method, by which, the firm does not pay tax on its exempt income, but it is neither entitled to deduct tax paid to its suppliers. It thus follows that the benefit in this case is only the amount of tax on the added value of the last firm in the chain.
• VAT and Non-profit organisations
We have already said that added value is formed by corporate profits and the wages they pay. Non-profit organisations do not operate for profit, so we may assume as a working hypothesis, that they have no net income and in turn, their value added is only formed of the wages they pay. If that is the case, taxation of
Non-profit organisations can be undertaken by imposing tax on the wages they pay, at a lower rate than the rate of VAT levied on firms. This is aimed at factoring in the tax paid by Non-profit organisations on their expenses, which they may not deduct, as opposed to firms. Alternatively, it may be argued that transactions, undertaken by Non-profit organisations are exempt of tax, and anyway they cannot reduce their tax liability by deducting the tax on their expenses. So with the assumption of no profit making, those organisations are taxed at a lower rate and only on wages.
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16.
Accountancy and Definition of Taxable Income
Accounting is the language of reporting on the results of business operations and on the financial position of the firm. Its goal is to report uniformly to all parties with an interest in the financial reports: owners, creditors, the authorities and the public.
Accounting is the method by which firms’ income is assessed and true assessments on their financial condition is made. This is undertaken by reference to periodic financial reports, which include the following:
Balance Sheet: in which information is given on the entirety of the firm's assets and debts and the difference between them, which forms the firm's equity true to the day in which the balance sheet has been prepared.
A statement of changes in shareholders' equity: as its title suggest, shows the additions and decreases, during the period, of equity of the firm.
Profit and Loss Statement shows a breakdown of revenues, expenses and the difference between them, which forms the profit or loss for the period.
Cash Flow Statement: reports on the use and origins of cash over the period, taking as a starting point, the amount of cash at the beginning of the period and details the movement of cash during the period: their origins and their uses, and ends in the cash balance at the end of the period.
Notes: are details of verbal and quantitative nature, add important information that is not listed in numbers in the reports abovementioned, such as: details on the accounting policies upon which the reports were prepared and changes to this policy, details on the amounts listed in the above reports, but which are not accessible therefrom only, as well as any information that could add to the information contained in the reports, and which the accountants consider is
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The reports are prepared by reference to internationally agreed upon principles and the following is a list of the more important ones:
The Conservatism Principle, by which reports will only detail profits actually achieved and expenditure predicted on high probability basis and thus, income, which is only expected and holds no substantive degree of certainty, will not be reported. The reports are prepared by management for the benefit of the shareholders and are aimed at providing a cautious report on the profits, made by the firm over the reporting period.
The Cost Principle involves all money transactions being recorded objectively, according to the historical cost at their date. This principle weakens during periods of inflation and there are countries in which the financial reports are prepared in accordance with the historical cost, subject to adjustments originating from inflation indices. This keeps the objectivity of the report on the one hand and on the other, provides current data.
International Financial Reporting Standards (IFRS) are international accounting principles, aimed at assessing the assets, contained in financial statements at their fair value, by presenting the firm as much as possible in real terms, according to expert appraisals.
The Matching Principle, according to which the income should be matched to the expenses and both, should be matched to the reported period. Thus, reported in the statement shall include all income over the period, and the expenditure reported shall include all expenses over the period, only which were expended in the process of making the income reported.
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Tax authorities in most countries accept these accounting principles for determining taxable income. They still however remain undecided on applying the
IFRS rules to their respective tax systems, because such application would dramatically change the manner in which taxable income is determined. Tax authorities have yet to digest the empirical implications of implementing these rules on tax collection, and changes in the methods for determination of income by way of application of these rules, may be expected in the future.
17. Taxing International Activity
•
Introduction
Not all income is naturally taxable in a taxpayer's country of residency. In order to tax, a link is required between the source of the income or the taxpayer and the taxing state. Thus there may be two tax jurisdictions: a territorial connection, i.e. the location of the source of income, the income generating process and its production and a residential link – determined by the characteristics of the taxpayer and its relationship to the state.
It is clear that state A cannot impose tax on the income of a resident of state B on income produced in state B or state C. State A’s taxing system may tax persons from across the world, who generated an income in state A, and may tax its own citizens for income generated in State A, B, or even C. For that reason, a resident of state A would be liable to pay tax at the state in which his/her taxable income was generated first, be that B or C, and will also be required to pay tax at his own state- A.
If so, such person is expected to pay double tax on income, originating in state B or C. International taxation therefore, involves two issues: upon which international income and to which taxpayer do local tax laws apply and how may prevention of double taxation be achieved?
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The Territorial Tax Method
This method of taxation imposes tax on income, generated within the territory of the taxing state, regardless of the place of residency of the earning entity. Tax is thus imposed on all income generated in that country, whether by its residents or otherwise. Of course, countries, the main of which produce is local, will prefer this method of taxation. It is also a fundamental and worldwide acceptable principle in taxation, that each state is entitled to impose tax on income generated, accrued or received within its territory by any person, being the ‘country of origin’. Since the purpose of tax is to fund the budget of the state, which makes available to anyone who generates an income in its territory, public services, as well as its infrastructure for their operations, it is appropriate that those who generate an income within its territory, contribute towards its budget. The state provides its residence, as well as to foreign residents who invest in business in its territory, protection over property, a legal system and policing, providing personal and property protection, which services are used by such foreign residents. According to the principle of benefit and burden, such services must be paid for by tax.
This method originates in the late 19th century and is known as the 'economic allegiance'. There is another method, known as ‘the force of attraction’, pursuant to which all international economic activity, which originates in the country of origin, but which is generated in consequence of that resident’s main activity, which takes place at his/her country of residence, shall be taxable by the country of residence, despite the prevailing method of taxation as a territorial one.
On the other hand, in a global village world, it is easy to disguise income as attributable to a country, which imposes low taxes. For instance, a web server selling goods (such as eBay) can be moved to any country and thus avoid the imposition of high tax rates to its owner, let alone where the server is owned by a foreign company. It is clear that mobilising the server to a tax-less state, will result with zero tax payment where territorial taxing rules apply and it is perhaps too
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The Residential Tax Method
Personal taxation does not necessarily exist in all taxing systems and is used in addition to the application of the territorial tax method. This method imposes tax in reliance of taxpayers’ residency, regardless of the place of generation of the income, that is, regardless of whether or not the income was generated in the country of residency. It is therefore clear that exporting countries, which are the home for owners of a large number of overseas companies, will prefer this method of taxing. This has been the choice, for instance, of the British Empire, reflecting its will to collect tax from all its residents, for their activities around the world.
A foreign citizen, who resides in a country that applies personal taxing rules, will be required to pay tax, firstly, to the country of origin (source of income) and only then to his country of residency, as we have already discussed the principle that the country of origin takes precedent over the country of residency to impose tax on such income.
There are also rules that regulate matters of corporate
residency because otherwise, a person could easily establish corporation in a lowtax country and route all his/her income from outside his own country thereto, thus avoiding tax.
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Relief from Double Taxing
The personnel tax system presents a number of problems, the most substantive of which is double taxation, which may be solved in two ways:
Domestic legislation: domestic law may make provisions to the effect. Either any tax paid to the country of source shall be deducted against the full local tax liability, or that taxing of the income, generated at the other country shall be calculated, deducting the amount of tax paid at the other country as an expense.
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International agreements: agreements between countries of residence and countries of origin, which regulate tax liability on income generated in others countries and divide the tax pie between them. These agreements regulate the issue of double taxation in various methods and are referred to as ‘double taxation treaties’. Domestic tax laws rules give effect and determine the superiority of the treaty over domestic law.
Parenthetically, we point out at the outset that there are many questions, arising from international taxation. For example, there could be dispute between two countries about the residence of particular person. The two countries will seek to make him/her a resident of their own and he/she will remain at the centre of the conflict, powerless to influence it. The conflict stems from the will of each of the countries to impose tax on the ‘resident’, without having to allow him/her credit on the tax, already paid to the other country.
It would have been expected that the countries of the world, through the UN, would formulate a unified global treaty to prevent double taxation however, such tax treaty doesn`t exist and most treaties are bilateral. Models of existing treaties are the American model, imposed by the Americans in any treaty which they are a party to, and the OECD model. The European Union is trying to formulate a treaty of its own, but without much success to date.
It is important to reiterate the primary tax entitlement, given to the country of origin, but it is not always clear which is that country for a particular income and it is possible that a taxpayer is levied with tax in both countries, claiming primacy entitlement. It is of significance that only the country of residence can allow credit on tax paid to the country of source and where both countries claim primacy, taxpayers may pay double tax. It should also be emphasised that tax credit may only be allowed in an amount of tax to be paid to the country of residence and so, it will always be the case that taxpayers pay the higher tax of the two countries.
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There are countries, which go even further and determine tax credit by using the
’income basket system’, where a basket may refer to a type of income, or country. According to this system, tax is calculated for each basket separately and credits are allowed with reference thereto only. Thus, it is possible that a taxpayer be in credit by one basket and in debit by another and an offset would not be permitted, to the effect that full tax is paid where due on any of the baskets.
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Issues in International Tax Planning
As in any other area of tax, in international taxing too, taxpayers make use of laws for purposes of tax planning. In international tax planning, reference is not only made to domestic legislation, but also to tax laws of other countries, and of course, to double tax treaties. The following is a brief review of some:
Use of Corporate Entities: as mentioned above, a person may establish a company in a low tax jurisdiction and direct all his/her international activity thereto, thus avoiding tax on such activity, until profits are shared as dividends. In order to tackle this difficulty, countries around the world legislated provisions, generally known as the CFC rules (Controlled Foreign Corporation), according to which, the profits of a foreign company, owned by a resident of the state but registered in another jurisdiction imposing lower taxation (such lower tax rate is usually slightly lower than the corporate tax rate in the country of residence), shall be regarded as dividends, distributed to shareholders, resident in the state.
Treaty Shopping: this kind of tax planning is based on tax benefits contained in tax treaties, agreed between countries. To take advantage of such treaties, companies are established in countries party to the treaties in order to take advantage of these tax benefits.
For instance, a resident of country A wishes to establish a factory in country B, where taxing on such factories and on dividends is low, say, for purposes hereof, zero%. Such a person would pay tax on the company’s earning at country B first,
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Suppose that country C is a party to a treaty with country B, which exempts its residents from tax on dividends distributed between companies of different jurisdiction. Suppose also that country A has a similar treaty with country C. For that reason, the resident of country will establish a company at country C, which will in turn establish a company in country B and which will purchase a real estate property for purpose of commercial letting. This way, no tax will be paid for the rental income at country B and no tax will be paid on the dividends, distributed between the company in country B to the company at country C, as well as on the dividends, distributed between countries C to A.
Such tax planning is tackled by domestic legislation and by application of the treaties. There is quite extensive case law, developed by the courts in many countries, which formulated the principle known as the ‘equitable owner of income’. According to this rule, all artificial foreign companies are ignored and the company, established in country C, shall be regarded as a resident company in country A, the country of residence of its shareholders.
Transfer Pricing: If a resident of a country is the owner of a number of companies, each in another jurisdiction, for instance, a pharmaceutical company, which owns an R&D laboratory, which also owns IP over a drug patent in one country, a pharmaceutical factory in a second country and a marketing company in yet a third country. Such person would wish to attribute royalties, due to the company holding the IP rights from the company of the owner of the factory, as a function of tax rates in both countries. This would also apply to the sale price of the pharmaceuticals, sold by the factory to the marketing company in the third country. If we assume, in the extreme, that the manufacturing company is exempt from tax by the second country, it will prefer to avoid any payment of royalties to the IP
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This issue is resolved by reference to the transfer pricing rules, which essentially take the form of domestic legislation, regulating fair pricing in transactions between related parties and companies. Thus, such rules will prevent the chance of non-payment of royalties and will determine the right price for the pharmaceuticals at the marketing country. In other words, transfer pricing rules are a complete theory, consisting of many models, which regulate the manner in which profits between related companies are shared.
Mishap: A true incident, which occurred in India. A pharmaceutical company, which applied unrealistic transfer prices, and so directed her profits to a low-tax country, was assessed with tax differentials worth billions of dollars, which was supported by the local Supreme Court. The company paid low tax over the income, redirected to the low-tax country, but was forced to pay tax over the same income in India as well.
E-commerce: what happens when commerce is undertaken by computer and the product is non-tangible and is provided over the internet? We add that the server is located at one country, the buyer in a second and the seller in yet a third, the company, which owns the server is located in a fourth country, the bank account of the company in a fifth country and its shareholders are residents of a sixth country. Which country should be allowed the first bite of tax? Which is the country of origin and what tax rules should be applied in determining tax in such an instance?
Encouragement of Economic Activity through Tax Exemption to Foreign
Investors: This is the place to note that sometime, tax exemption is merely a
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We assume that the investor will be liable to pay tax in his country of residence on his/her income from such letting, although he invests in the country of origin. The outcome is that instead of tax being paid in the country of origin, it will rather be paid at the country of residence. If tax was applied at the country of source, at a rate, similar to the rate, applied at the country of residence, the investor will have paid the very same amount, but, to the country of origin. Stupidity!
18. Corporate and Shareholders Taxing
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Introduction
A company is defined by law as an accumulation of contracts. In other words, the mere existence of a company is depended upon a contract between itself and the public, additional, its activity is sourced in contracts. The company itself cannot enjoy the public services provided by the state; those who do enjoy them are its shareholders. This matter raises a number of theoretical questions, dealing with corporate taxing and its justification together with the manner and extent of imposing corporation tax.
•
The Justification to impose Corporate Tax
Economically, a company is the extension of its shareholders, who serves them to maximize profits. The company itself does not use public services, nor does it consume. Income is defined as consumption plus savings; since savings actually is future consumption, it follows apparently, that companies have no income.
Though, all countries impose tax on companies. The question that arises here is whether the company, which is merely a channel for the transference of revenue to its shareholders, should be taxed independently, or should its shareholder be taxed directly. 59
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Theories on the imposition of tax and on distribution of the burden of taxation are not compatible with the corporate model, but are compatible with the model of taxing its shareholders, only through which it is possible to implement the rules of justice, of equality, of ability to pay and others. With reference to indirect taxing, the company itself does not consume and for that reason, it will not be imposed with consumption taxes. For those reasons, it is necessary to choose between the legal concept of separation between the company and its shareholders and the economic viewpoint that the company is a conduit for its shareholders’ wealth.
Justification for imposing Corporate Tax is based, among others, on the following arguments: Tax should be paid for the protection from liability which the law provides the shareholders; reducing the market failure known as ‘moral hazard’
– the separate liability between the corporate and the shareholders, leads to excessive risks that the results of which are laid upon the public, and by imposing tax the damage that derives from them will be reduced/moderated; using tax to limit the power, possessed by giant corporations, that have an extended influence on the economy; there is also the "agent issue" by which there is a different interest between shareholders (the transmitter) and the CEO`s (the delegates).
Taxation may somewhat dull the inherent conflict between them.
Answers to these and other questions will determine what tax system should be applied, as tax may be imposed in a variety of ways. The scale moves across the range, from the double taxation model to the full transparency model. There are those who believe that companies should pay tax separately from their shareholders, but they do not take into account that the payment of tax by the company reduces its resources to distribute dividends to its shareholders, which means that tax is indirectly paid by the shareholders. Therefore, this form of taxation operates as double taxation and thus violates the rules of justice.
•
The Full Transparency Model
According to this model, tax is imposed by reference to the economic reality and not according to legal rules. For taxation, the financial position of the company is
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Dr. Jack Itzhak Barsheshet, Ph.D. transparent, and the tax will be levied upon each of its shareholders, according to their respective marginal tax rate.
This model is found in most of the world in taxation of partnerships and in several countries, on a voluntary basis, in corporate taxing. We can find some differences between the two; usually the assets of a partnership, as well as its revenues, belong to its partners directly. However in transparent companies, all assets and revenues belong to the company itself and only the ‘bottom line’ - the profit, is attributed to its shareholders and for that reason, the Full Transparency model exempts dividends, distributed by a transparent company. For this reason, this model can be successful where there is a small number of shareholders and where their substitution occurs rarely.
•
The Double Taxing Model
According to this model the company pays tax according to a corporate tax rate, whilst its shareholders pay personal tax according to their marginal income tax rate. Suppose for example that corporate tax is 25% and that its shareholder’s marginal tax rate, which is equal to the maximum marginal tax rate applicable, stands at 40% and that the income stands at 100,000. In such a case we shall see that the total tax on the income will be: 25,000 paid by the company and 30,000 tax will be paid on the remaining 75,000, so the net income will stand on 45,000.
That is to say that the overall tax will be 55%.
Clearly, in such a case, no tax-payer would have an interest in operating through a company and therefor, in order to encourage commercial activity through corporates, tax should be imposed at a total rate, which includes both corporate tax and shareholders’ personal tax, not exceeding the maximum marginal tax rate.
If we take the above mentioned example and change the rate of tax on dividends to 20%, the overall taxing would stand at 40,000, i.e. at 40%. This rate is the same as the maximum marginal tax rate. This is the break-even-point. However, this still does not resolve the issue, arising from the taxation of those whose marginal tax rate stands below of the maximum marginal tax rate.
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•
The Corporate Value Model
According to this model, the value of the company’s shares is assessed and the increase in their value is calculated. In order to determine the taxable income, any dividend paid to the shareholders that year is added to that value and the overall result would be taxed at the respective marginal tax rate. This model has several disadvantages: it relies on assessments and it is applicable only to companies, which shares are traded in a market. We have already mentioned another point, which is that imposing tax on value is unjust, because it may result in a situation, where a shareholder must sell part of his shareholdings, in order to fund his/her tax liability, which violates the good tax rules.
•
Other Methods – Partial Interlacements
We have seen that the various methods of taxation seek to generate one method, which will combine all rules of equality and justice, horizontal and vertical. Some prefer that companies bear the entire tax liability and that dividends will be tax exempt. This method inherently imposes a maximum marginal tax rate, which causes the tax imposed to be unjust. Another method considers that tax should only be paid when dividend is distributed. The rate thereof should be the shareholder’s marginal tax rate. This method has its flaws as well, because it ignores the reasons for which tax should be imposed on corporations and it also defers the tax payment date to the date upon dividends are distributed – an obvious and unjustified tax benefit.
There were many attempts to identify the right method of corporate taxing and their shareholders, but only one, which considers corporate taxing as an advance on the tax due by their shareholders may achieve the goal. It is a method of partial integration and according to this model, corporate tax is imposed on the company, but its dividends distributed shall be considered as deductible expenses and will be applied with negative taxing. Thus, at the time of distribution of dividends, the company will become entitled to reimbursement in tax in the value of the dividend
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Dr. Jack Itzhak Barsheshet, Ph.D. distributed times the corporate tax rate, but its shareholders will pay tax in accordance with to their own marginal tax rate.
We will demonstrate: a company has an income of 100,000 and it paid corporate tax of 25,000, it has a sum of 75,000 left of profits to share. If it distributes
75,000 in dividends, it shall become entitled to a 25,000 tax refund, in other words, to conclude, it has the possibility to distribute a dividend of a total of
100,000. If so, at the moment of the actual distribution of the dividend, the company will have a tax refund of 25,000, while its shareholders will have to pay tax in accordance with their marginal tax rate. If we assume that the marginal tax rate of the shareholders stands on 30%, then they will have a tax liability of
30,000 and the company will have a tax refund of 25,000- if we can set these sums off then according to this method the shareholders have to pay only 5,000. The outcome is that taxing the entire sum of the dividend distributed at the shareholders’ marginal tax rate, together with the refund of the tax that the company paid on this sum leads to justice taxation.
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Dr. Jack Itzhak Barsheshet, Ph.D.
Table of Contents
Chapter One – Introduction
1. Preface
4
2. Jurisdiction to impose Tax
6
The Social Treaty and the Origin of Taxing
6
Historical Development
7
The Purpose of Tax
8
"Normative Tax Structure" and "Tax Expenditures"
8
Taxing and Justice
10
Distribution of Tax Burden
13
Does tax breaches Fundamental Rights?
16
Chapter Two – Postulates
3. Terms
20
Tax Unit
20
Positive Tax
20
Negative Tax
20
Direct Tax
20
Indirect Taxing
21
4. Mandatory Payments
21
Definition of Tax
21
Price
22
Fee
22
Participation Fee
23
Municipal (propriety) Tax
23
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
5. Differentiating between Sorts of Mandatory Payments
24
The Tests for Differentiation
24
The significance of Differentiation
24
6. Public goods
24
7. Market Failures
25
8. Incidence of Tax
28
9. Principals of a Good Tax system
31
10. Neutrality in Taxing
34
11. Effective Tax
35
12. Efficiency of the Method of Taxing
36
13. The Search for a 'Just' Tax
37
Progressive Tax
37
Regressive Tax
39
Flat Tax
39
Tax Credits and Tax Deductions
40
Pigovian Taxing
41
14. Deferral
43
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Dr. Jack Itzhak Barsheshet, Ph.D.
Chapter Three – Topics
15. Value Added Tax (VAT)
44
Introduction
44
Added Value
44
Methods of Imposing VAT
45
Further Problems with VAT
46
Battling VAT Evasion
47
Tax Regressivity
48
Tax Exemption as opposed to Zero Tax Rate
49
VAT and Non-profit organisations
49
16. Accountancy and Definition of Taxable Income
50
17. Taxing International Activity
52
Introduction
52
The Territorial Tax Method
53
The Residential Tax Method
54
Relief from Double Taxing
54
Issues in International Tax Planning
56
18. Corporate & Shareholders Taxing
59
Introduction
59
The Justification to impose Corporate Tax
59
The Full Transparency Model
60
The Double Taxing Model
61
The Corporate Value Model
62
Other Methods – Partial Interlacement
62
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
Chapter One – Introduction
1. Preface
In observing social organisations, it is possible to detect an identical pattern of behaviour: every organisation finances its activity via contributions from its members. No meaningful activity is possible without a budget, the more so, when funding the operations and budget of the country. Pursuant to an agreement, manifested in a ‘Social Treaty’ a large number of inhabitants were united under one state structure, to an end of achieving their goals as a group. By virtue of such agreement, they voluntarily took upon themselves to fund the activities of the state, i.e., its budget. Such funding was achieved through the state’s tax laws and mechanisms. At first glance, tax laws seem to compromise tax payers’ fundamental proprietary rights, but the state cannot avoid it - we will discuss the question of whether taxing forms injury to rights at all, or should the outcome be defined otherwise later below. It is worth noting that there are those who claim that funding states’ budgets is possible without recourse to taxing, but such claims are without merit. In the course of studying, we shall substantially analyse why that is so, but put simply, this is clear because the tax system is the very bedrock of the state’s budget.
Tax laws focus on tax collection methods and the distribution of the burden between all the state’s residents. They are responsible for creating order in the government’s tax revenues as its main mean of funding. Note, however, that attention and public debate surrounds mainly government spending, rather than its revenue, i.e., what does the government do with the money it has, or in other words - how is the budget divided between the various interests, and less dealing with questions of how does the burden calculates and how is tax collected. This leads us to the conclusion that benefits, granted to certain groups should, also by
4
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. virtue of the need for transparency, be granted through the state budget, rather than result from a tax benefit.
We have said that political, public and constitutional thinking focuses mainly on government spending and less on the collection of tax, which is forms government revenue. It follows that the fundamental questions, concerning distributive justice, social rights and efficiency, do not constitute a substantial part of public debate, although ostensibly, these issues are essential in determining how the burden of tax be distributed and are of significant social and sociological implications.
Today, public discourse on tax law increasingly takes precedent and focuses more on how tax is imposed, questions of distributive justice and recognition of social rights protection – such because the tax system is also designed to achieve goals of ‘redistribution’ of wealth in society. Although right wing economic literature support ‘freely market’ and refuses to consider redistribution, focusing on increasing total wealth, it clearly states that the only effective way to redistribution is through the tax mechanism.
Apart from these questions other questions also arise, those of justice in the distribution of the burden of tax and intergenerational justice - as the government finances its operations through borrowing, it creates a situation where the current generation enjoys services that government provides, whilst future generations are the ones who would fund them through tax that will be imposed on them.
Tax can affect all aspects of life: economic activity, supply and demand of work, organisation of business, capital structure of corporations, reinvestment of revenue, location of the business and residence, selection of industry in which the firm operates, encouragement of research and savings and many other effects. We shall see that at the foundation of the theory we shall study, stand rules that draw their essence from many doctrines, such as philosophy, accounting, public funding, economy, jurisprudence and more. This makes tax theory, complex, multi-disciplinary and even fascinating and interesting.
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Dr. Jack Itzhak Barsheshet, Ph.D.
In conclusion of this part, we shall quote Benjamin Franklin, who said: “In this world nothing can be said to be certain, except death and taxes”. Therefore, we can only delay their introduction!!!
2. Jurisdiction to impose Tax
•
The Social Treaty and the Origin of Taxing
The Social Treaty is a political theory, written by philosopher Jean-Jacques
Rousseau and following Thomas Hobbes's theory of the State of Nature.
According to Hobbes, in the state of nature, humans live in independence of each other and do not maintain sufficient contact between them to create a state of peace or war and the natural state is one of perpetual ignorance that must be avoided. In this situation, there is no private property and the only property that is owned, are those things that no man wants. In this situation, the strong rules, not by virtue of legitimacy, but by power itself. "Man is free in this situation as much as his might takes him". He has no protection from others. We can compare this to the position of animals in the wild.
According to Rousseau, for this reason individuals communicate with each other by way of a social agreement, which regulates their way of life, to the end of achieving more with the help of others – more than they could achieve in the natural state. By force of the social treaty, each individual commits to his/her sovereign and waives his/her natural freedom, in exchange of which he/she secures civil freedoms and proprietary rights.
We can say that historically, when individuals started living in communities, they formed orderly government bodies, whose role included, among other things, protection of borders and maintaining the welfare and other interests of all residents. Consequently, there became a need to fund such activities and every
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. individual had to contribute his/her share, thereby becoming entitled to enjoy the services that government provides.
It is easy to understand therefore that the tax must not only be imposed by representatives of the people, the Legislature, it must also meet constitutional criteria of justice, equality, fairness, dignity and more. The role of the
Constitutional Court is to examine whether or not tax laws are the compliant with constitutional criteria. Thus, for instance, Constitutional Courts in the USA and
Germany have revoked tax legislation for non-compliance with constitutional criteria. •
Historical Development
The first recorded tax system is Egypt’s (2800-3000 BC). There is evidence that
Pharaoh taxed his people. The Bible also mentions taxes, Genesis 47:24 states:
“But when the crop comes in, give a fifth of it to Pharaoh. The other four-fifths you may keep as seed for the fields and as food for yourselves and your households and your children”. Tax types in ancient times mainly took the form of customs and production tax, mainly oil.
In the Roman Empire, tax was imposed on land (jugim). There is evidence of taxation in Europe of the 17th century. There is also evidence of a taxation rate of
15% - 20%, imposed in France, the Netherlands and Scandinavia. In times of war in the 18th century and early 19th century tax rates increased significantly, as war became more expensive and governments became more centralised.
Over time the ancient taxation mechanism evolved into an elaborate system, which enforced clear rules on the identity of taxpayers, when are they due and for what. Although this was done over many years, the principle was the same in every village, kingdom and empire in human history. Residents paid a tax to secure security and enjoy the rights and services, provided by the governing body, to which they were subject.
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•
The Purpose of Tax
Taxing has one basic purpose, which is the fund of the governing body, the price of civilisation. The public sector is funded through tax, and taxes are a major component in the state, local authorities and other public bodies’ funding. Many governments use tax systems for other purposes, resulting from policy considerations. Many economists oppose the use of the tax tools for anything other than its natural purpose - funding the budget. Such objectors argue that achieving these objectives should be implemented through the government expenditure budget.
States use tax mechanisms to affect redistribution of wealth in society, to encourage economic activity and to direct the behaviour of residents, for example, by tax exempting investors in areas, or branches of the economy it wishes to develop, to influence companies to set up factories in industries and areas preferred; the imposition of custom duties on imported goods encourages buying local produce; cancellation of custom duties on vehicle safety aids, for example, increases road safety; increasing tax rates on cigarettes and alcohol encourages reduction in consumption; progressive taxation and granting of allowances and encouraging investment in rent-designated housing construction through tax exemption on income from rental apartments and more.
•
"Normative Tax Structure" and "Tax Expenditures"
As noted, the main role of taxation is funding the state’s budget. For other purposes, the traditional approach prefers their funding through the government expenditure budget, rather than through tax revenues, which are part of the normative tax system. In other words, firstly, the government should collect all tax due to it without any exemptions and only then, it may distribute it in accordance with its operations budget, as approved by the legislature.
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Dr. Jack Itzhak Barsheshet, Ph.D.
The tax system, unlike the state’s expenditure budget, is not transparent. Whilst budgets form part of public debate, is known and a subject to controls and the executive branch is not allowed to deviate therefrom, tax benefits are not known or measurable, neither in advance and sometimes, not even in retrospect, it is not accessible and changes thereto require inflexible legislation. There is inherent difficulty in measuring various tax benefits because tax authorities lack tools for measuring benefits granted, not to mention that there are many influential and interested people in this field, who can tempt decision makers to distort the normative tax structure in different ways that are not transparent to the public.
Politicians like tax benefits, called ‘tax expenditures’; they give them power and prestige. This is very convenient, especially since the financial implication of the benefits is not publicised and in many cases is not measured at all. Such tax benefits violate the rules of justice in taxation and should be visible and publicised. The right way is to make them part of the state budget, rather than allowing them to exist through tax benefits. Another way that was proposed is to form a tax expenditure budget, which would be visible to the public.
The tendency in the world is to avoid achieving sub-goals through the tax system, subject to the distinction between ‘tax expenditures’ and ‘normative tax structure’. The normative structure shall include any provision that is consistent with the relevant fundamental principles of theoretical tax structure and of the distribution of the tax burden and imposition, such as the principle of the ability to pay, or the principle of benefit and burden to public services. All other tax purposes shall remain outside the normative tax structure and to the extent that they are included in tax laws, they will be considered as tax expenditures.
Tax expenditure is illegitimate because it is not part of the normative tax structure such as tax benefits for dwarves. The question of what should be included in the normative structure is part of a political debate. Is tax benefit for dwarfs tax expenditure and therefore a part of the state budget, or is it a part of the normative tax structure, which must be examined against the principles of justice and equality. Deeper consideration of the issue will lead to the question of whether fundamental taxing principles require that dwarfs pay less tax, because only then
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. will such benefit form part of the normative tax structure, or, if the need that dwarfs pay less tax is a rather moral or social consideration, it should then form part of the state budget.
On the other hand, when a government is unable to provide a public service to a particular population, say as an example, providing an access road to isolated villages, then there is no justification to charge them with full tax rates and it would be justified to grant them an exemption. Thus, such a benefit is both efficient and forms part of the normative tax structure. That would not be the case, where the exemption is granted as part of an ideological consideration, such as an attempt to encourage settlement in those remote villages.
•
Taxing and Justice
Distribution of wealth in society stems from the activities of various individuals, but chance and luck has a major role in the results of this activity, for better or worse. Children born to poor families or in isolated communities do not enjoy an equal opportunity to those who are born to rich families in major cities. Such neglect should be regarded as the failure of the government to fulfil its obligations to those populations. For this reason there is another role that government has, which is the rectification of the distribution of wealth, as a social goal, even at the expense of economic efficiency. One of the government’s functions is to balance between efficiency and equality.
The social groups that support the notion that the purpose of tax is only to fund the budget of the state, seek a narrow government with minimal budget and taxation, whilst leaving the private sector to provide the remaining public services. They say that an ‘invisible hand’ will produce the optimal economic efficiency. On the other hand the perception that government's role is to create distributive justice, requires a broader government and therefore higher taxation to finance its budget. There are no empirical studies that prove the utilitarian arguments, but what is clear from empirical studies is that investment in human and social capital leads to long-term
10
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. economic growth. If so, distributive justice in education becomes more efficient in the long term.
Even utilitarian demand social justice in the name of economic efficiency. The argument is that the greater social justice, the greater solidarity and lesser crime.
Thus will public expenditure be reduced (police, Judges and prison staff) and income from tax will increase, as most tax evaders will start paying taxes.
Consequently tax burden will be reduced and the additional income will be directed to strengthen economic activity. Personal and associated welfare will grow, which will trigger solidarity, which in turn will attract investments, and so on and so forth.
Having determined that the distribution of the burden of tax should be undertaken in a fair manner, whilst observing principles of equality and justice, we must turn to seek those rules, which will stand at the basis of just distribution of the burden.
In seeking such rules, we might, on the one hand, find ourselves diving into the depths of ancient philosophical questions of the essence of justice: distributive, compensatory, material, formal or divine, which take us back to the days of Greek philosophical. On the other hand however, there is concern that we might be drawn to determine rather subjective rules of justice that are not acceptable to everyone.
Not only that, but rules of justice cannot be quantified and therefore rules must be based on principles of equity, which are quantifiable - such as equality and uniqueness. According to the rules of equity we discuss two types of ‘justice’ in taxation: the first is that equal people share the burden of taxing equally and this is the
Horizontal Equity Rule; the other is that different people share the tax burden differently and this is the Vertical Equity Rule. These rules lead to the question of the criteria for determining equality and difference between people.
But in order to achieve equality and distribution of the tax burden, we must realise the purpose of taxing, including its sub-goals, redistribution of wealth in society or the promotion of economic policy, which makes the task more difficult and
11
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. complex. The question of what is just distribution raises controversy amongst scholars, each according to his/her perception.
Distributive justice is achieved where the distribution of wealth in society corresponds with the criteria of equality. Philosopher John Rawls in his book
‘Theory of Justice’ (1972) describes justice as ‘fairness’. He argues that just appropriate distributive policy should aim at improving the condition of the most poor in society and that inequality in distribution of resources, may only be justified, if it is aimed at achieving that goal. Other philosophers (especially liberals) argue that distribution of resources is just as long as it is not a result of coercion or violence. That is, the distribution was achieved voluntarily. According to philosopher Nozick, a just situation is where it has been achieved as a result of just actions and with no violence.
Another proposed formula, called the ‘capabilities approach’, states that achieving distributive justice requires that everyone will be able to realise itself and that therefore it is necessary to have access to basic resources and opportunities. This approach requires the state to provide the means for the weak that will enable them such access and dignified living conditions. Utilitarian believe that just distribution is one which leads to maximisation of the welfare to most residents. Today there are school of thoughts, according to which distributive justice must be implemented at a global level, against the background of inequality in living standards in developed countries, versus developing countries. The importance of the two types of justice (horizontal and vertical) is reflected in both the moral and practical levels: in horizontal justice, there is a moral aspect of equal treatment of equals and the practical aspect of preventing a feeling of discrimination. Vertical justice too, has a twofold aspect, the moral one, whereby equal tax must not be applied to different people, where more may be collected from those who have and less from those who do not, and the practical aspect of the sense of equality, whereby the ‘pain’ of the rich and that of the poor, resulting from the payment of tax - should be similar.
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Dr. Jack Itzhak Barsheshet, Ph.D.
Therefore it is only left to determine what is ‘equal’ and what is ‘different’ and the extent of relevance of the extent of such difference.
If two people are earning 100, but suppose one of them is a dwarf and the other is not, should they pay equal or different tax? In other words, how relevant is the question of dwarfism to the rate of tax? If it is relevant, then this relates to a normative tax structure and if it is not, then a difference in applied rates would be characterised as tax expenditure. What if the dwarf was disabled, would that justify a difference in taxation, based on the vertical justice rule? Are the dwarf’s special needs as a disabled person relevant to the payable tax rate? Is relief in disabled’s taxing a question of equality in taxation, or is it a choice the state makes to assist the disabled, as a social consideration?
•
Distribution of Tax Burden
In the ancient world, it was common to impose ‘poll tax’, which imposed uniform tax on all residents. During time, probably, the vast majority of people were equal in income and financial capability. Such taxing was part of overall taxes, imposed under the laws of the Kingdom (such as customs and land taxes), but also and mainly, by force of the laws of religion (tenth, gather, oversight, edge etc.).
Against this background, the poll tax could be considered fair and equitable. It was considered efficient, simple and most convenient to collect. Today, due to vast difference between people, it is considered unjust.
Attempts to impose such a tax in modern times failed. It was in the 60's, when the government of Margaret Thatcher sought to impose a poll tax on the people of
London in order to save the collapsing municipal purse. That experience prompted substantive street riots and threatened Mrs Thatcher’s administration, which lead eventually to the abandonment of the idea.
Distribution of tax burden connects to questions of justice in taxation, since it deals with the question of the most just and fair method of distributing the burden between residents. Distribution of the burden must take into account both
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. economic efficiency and equality, reflected in the rules of distributive justice. In order to achieve these results, distribution must consider the general diminishing marginal effectiveness of money, out of which stem two principles: the principle of benefit and burden and the principle of the ability to pay.
The principle of diminishing marginal effectiveness of money: the principle holds that the marginal effectiveness produced by a person from his/her income, decreases with each additional unit of money earned. Every person has his/her own personal curve, but we can apply the principle to all. Accordingly, if tax is imposed equally, the rich's pain, derived from the tax imposed on the last unit of money he/she earned would be lesser than the pain of the poor, paying tax for his/ her last unit earned, ergo, in order to match the pain of loss, resulting from the payment of tax, the rich would have to pay more tax than the poor.
The principle of Benefit and Burden: If one undertakes a kind of privatisation of public services and converts tax into a sort of price therefor, then it is appropriate to examine the extent of use thereof by each resident and accordingly, how much should be charged from him/her. Each person should pay a tax, corresponding to the degree of benefit he/she derives from the public services, provided by government. This is such a romantic idea that will be difficult to implement, but quite obviously, the rich will have the benefit of more education, roads, justice system, etc. than the poor would and in other words, the rich consumes more public services than the poor, this is why he has to pay more tax.
The principle of the ability to pay: The principle states that each resident should be charged with the tax he/she is able to pay. This principle draws its essence from the principles of horizontal and vertical justice and is influenced by the questions these principles raise. Public discourse on this principle persists in developed countries and involves the question of what is the relevant difference between people, for determining the capability to pay. Discourse exists less in lesser developed countries and close examination of this definition raises difficult questions, for example:
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Dr. Jack Itzhak Barsheshet, Ph.D.
Some argue that tax should be levied by reference to talent, i.e. the capability to produce capability to pay. This is a tool within the boundaries of distributive justice, which seeks to impose greater tax on those who are talented, but do not generate income, than on those, who are less talented, but do work hard to generate income. The tax imposed on both does take into account their respective income, but does not take into account the wasted talent of the first and especially the positive externalisation (the benefit of the entire population) of the fruit of the efforts of the less talented.
Another argument is that tax should be imposed based on the consumption of each individual. Under this approach, consumption should reflect the consumer's capability to pay. However, implementation of this approach introduces nonpayment of tax on savings income, which is not ‘consumed’ according to the formula: I = C + S (I=Income, C=Consumption, S=Saving). In contrast, savings will be consumed at some point in the future, so accordingly, tax thereon would be imposed, albeit later.
Another approach is to impose tax by reference to the increase in wealth, which serves as an indication of the capability to pay. A person may find him/herself in a situation where his/her wealth will have increased, without in fact having an income at all and accordingly, there shall be no basis to impose tax. Increase in wealth may be measured by the following formula: I = W2 - W1 + C, where I
(income) = W2 (wealth at the end of the year) – (minus) W1 (wealth at the beginning of year) + (plus) C (annual consumption).
The limitation of this method is the place of human capital in all of the assets of a person. Avoiding the measuring of human capital would produce a breach of the principle of horizontal justice. This also raises second-tier issues, such as the inability to measure wealth or to measure annual consumption.
All thinkers and scholars believe that tax should be imposed differentially. Even
Nozick, who is a radical in his approach, agrees that there is need to reduce tax levies for those with low capability. His reasoning is that the protection of natural rights is provided by the government to both the rich and poor, albeit the latter
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. enjoys less and would not have paid for such rights, for lack of capability. Since the majority imposes it view on the minority, this requires a process of
‘compensatory justice’.
For practical reasons, states tend to impose tax (and such method is accepted worldwide) only on income, the definition of which varies from one tax system to the other. The questions arising from imposing tax on income are by definition: what is taxed income, how it is measured and what is the date of its tax assessment? There are a number of possible acceptable stages in determining the date on which this income is part of the tax assessment, which are: the point in time of the potential to generate it, its actual production date, the date of sale
(regardless of when cash transactions occur) - accrual basis, or at the time physical cash is actually received or paid out -cash basis, all subject to special provisions of the law, or to generally accepted accounting principles (GAAP).
Illustratively: a man who came to own an oil well, which has great potential for income, when should he be taxed? Clearly, income will be taxed at some point in any case, but the question is when is the correct point to impose tax liability, pursuant to the principles mentioned above: somewhere between the edges of the
‘discovery’ of the oil, upon actual cash payment for the sale or somewhere in between those points.
•
Does tax breaches Fundamental Rights
Taxation in its traditional definition forms taking. The taking of tax can violate proprietary rights, equality, standards of living, freedom of occupation, freedom and privacy and could even depress economic activity. Under these circumstances, the question arises whether taxpayers have the choice of not paying tax imposed.
We all know the phrase, claimed by the Americans during the Boston tax revolt
(known as ‘The Boston Tea Party’) according to which "No Taxation without
Representation".
We have already defined tax as the price for civilization, i.e. a necessary evil, or perhaps this is not the correct definition? Perhaps this is just the price of
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Dr. Jack Itzhak Barsheshet, Ph.D. maintaining a political organisational structure. Accordingly, it is necessary that tax be imposed as part of the social treaty and by an authorised representative, i.e. in law. Accordingly, tax should be viewed as the agreement of the public to fund the state budget, subject to constitutional judicial review.
The impact of taxing on fundamental rights, as seen, may take several forms.
Firstly, if the principle of the ability to pay is not implemented and tax is imposed on income that is insufficient to allow basic existence, it is unfair to put a person in a dilemma of priority of who comes first, the state or the family. Another compromise might be that to the freedom of employment, where one sector enjoys subsidies by form of negative taxing, it follows that other sectors that do not enjoy such suffer damage to their competitiveness. The heart of the discussion is the claim that taxing violates the proprietary right, i.e., whether by its very definition, taxing violates such right.
The answer is unequivocal, which may be seen through the question of the effect of taxing on labour supply. Leisure consumption is a substitute for work; when we consume leisure, we lose working hours. Suppose a person earns 10 per hour of work and the rate of tax imposed on him was raised from 20% to 40%. That person could believe that as long as his/her net income was 8, he preferred to continue working, rather than consuming leisure. But now, that the raising of the tax burden leaves him/her with only 6 net earnings, it is not worth it to continue to work and that it is better to consume leisure rather than work. On the other hand, that person could say that because he earns only six, it is not enough for him and he/she must work more, in order to have enough to be able to consume leisure. In this case the two effects offset one another, but no empirical studies exist, that support this economic theory.
The approach of philosopher Jeremy Bentheim: According to that approach, proprietary rights do not exist in the natural state, but derive from a set of laws, which acknowledges them. Tax is also the creation of law and therefore affects the definition of proprietary rights in a manner that deducts the value of tax therefrom, so that ab initio, it includes the value of that component. In other words, both tax and proprietary rights are the creatures of the same set of laws, without which,
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Dr. Jack Itzhak Barsheshet, Ph.D. neither would exist. Moreover, if proprietary rights are a creation of law and taxation is the creation of the same law, then it follows that proprietary rights will be defined by such law in a more limited way.
The approach of philosopher Jean-Jacques Rousseau: By the very agreement, reflected in the social treaty, residents of the state waive proprietary rights in its favour. Therefore, proprietary rights already presuppose the tax burden and proprietary rights are therefore given lesser standing and are awarded to residents by the state, having already been discounted by the value of tax component.
It is clear that both approaches still require fair and just distribution of proprietary interests by the state, as between it and its subjects, and therefore such distribution must be based upon transparent constitutional rules and be subject to judicial review. The approach of philosopher Robert Nozick: This approach is different from the other approaches. Nozick's view is that all tax violates proprietary rights, but that such injury must be subject to criteria of constitutional rules, which are subject to judicial review. He illustrates this approach by the captivating argument that the imposition of tax on labour forms expropriation of the employee's time and therefore makes him a compulsion labourer. Nozick of course ignores other aspects, relevant hereto, such as the employee's use of public capital to generate income. The partnership approach of philosopher John Locke – "The Labour Theory of
Value": Accumulating property is a process that involves firms, utilising the manufacturing facilities, finance, labour and social capital. Social capital is manifested in infrastructure, the legal system, freedom of contract, education, security, health, foreign relations, economic stability and more. All these are provided by the public through the state and so, there exists a kind of partnership between the state and the firms, where tax is found in the distribution of resulting income. This mechanism must be qualified in that the state indeed receives only its part and does not dip into firms’ share, tax only serving as a mechanism for distribution. 18
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The cost of access to public services approach: If public services were provided via the free market mechanism, firms were supposed to pay for them. The existence of market failures and of social values, require that the state provides such services. There is no merit in the question of free choice of purchasing services in the private sector, compared with the forced choice imposed upon society, to purchase these services from the state. Even if free choice was available, it would have been a quantitative choice of the extent of consumption, rather than a qualitative choice of whether to consume, since consumption of these services is natural and automatic. Therefore, tax is actually paid for services rendered. The above collected information shows that as long as we elect representatives to serve as legislatures and taxes are imposed by legislated rules, and these rules are subject to constitutional judicial review as to their compatibility to constitutional fundamental principles, i.e., they comply with the definition of ‘good tax’, they do not violate fundamental rights and inasmuch as they do, they shall be revoked by the Constitutional Court.
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Chapter Two – Postulates
3. Terms
•
Tax Unit
Tax unit is the taxed entity. It can be an individual, a family, partnership, company, etc. and the determination of what is the relevant tax unit for purpose of taxing has far reaching implications.
For demonstration purposes – the taxing of a family can be undertaken in several ways: Taxation of each individual within the family cell, taxation of the unit as a whole or separate taxation for each individual within the cell, by dividing its entire revenue between the couple. Each method will lead to a different result.
•
Positive Tax
Tax paid to the government by all taxpayers. This is the classic structure of tax.
•
Negative Tax
Payments paid to residents by government, such as subsidies, transfer payments and even classic negative tax. Negative tax is an unhealthy phenomena and is a mirror image of positive tax.
•
Direct Tax
This is tax, which is paid by the formal entity which in fact owes it. For instance, an individual or a company pay tax for their income. There are a number of direct taxes, the most known of which is income tax. In addition, there is tax on capital gains, raffle gains, gifts, inheritance and more.
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Dr. Jack Itzhak Barsheshet, Ph.D.
•
Indirect Taxing
This tax is characterised by that it forms part of the price of the product or service upon which it is imposed. The formal entity, which is levied with the tax, is the seller of goods, or the service provider, although they are not the ones who fund it by adding its value to the price asked. Examples of indirect taxes are VAT, customs or purchase tax, all allegedly imposed on the seller or provider, but rolled onto their clients, forming part of the price asked for the product or service.
4. Mandatory Payments
•
Definition of Tax
Tax is defined as a sum of money, for which there is no direct equivalent value.
The definition consists of three components, each of which creates its own difficulties: payment, coercion and consideration.
Is it at all possible to impose tax on all citizens, when there is allegedly an option to avoid payment of tax, by avoiding work, which negates the requirement to pay income tax, or by avoiding purchase of products or services, which negates payment of VAT? On the face of it, technically, one cannot force a person to consume and indeed, there are those who do not pay tax everywhere. This is the reason that taxes are imposed where a person works or consumes. The very coercive nature of tax collecting originates in those free riders, who use public services without paying for them. They are similar to those, who take products from a shop without paying for them and in order to ensure that they pay due tax, it is necessary for tax to be mandatory and liable to be collected by force.
Theoretically at least, pursuant to the social treaty, there should be equal-valued consideration for the tax paid (tax efficiency). What form such consideration takes and how may it be measured are difficult issues to quantify.
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Within the definition of tax, it is common to include classic tax, positive and negative tax, as well as supports and subsidies, provided by government. In broad terms, tax is the total net of resources that the state receives from the public. The collection of tax and the use thereof is under constant scrutiny, because it involves compulsory depriving of private property in favour of the collector.
•
Price
Payment paid, in consequence of a voluntary act, mostly in the private sector, but not always. It involves voluntary payment for products, or services, consideration for which is usually equal in value and does not include elements of tax. The legal structure does not usually interfere with questions of price, as opposed to issues of tax, with which the system should and is obliged to interfere. We know of essential services, which price includes an element of taxation, such as the price of water, the charge for which may change due to political considerations, rather than economical ones (demand and offer). These are mostly governmental monopolies, upon which the forces of the market have no effect.
•
Fee
Payment, which may either be imposed or chosen, dependent upon its nature, against which there is direct consideration in public service or product, but which is not equal-valued to the fee paid, such as licensing fee. Where no service is rendered, no fee is payable. Whilst direct consideration is involved, it would not necessarily be equal to the fee paid and often it will be higher than the cost element for the service rendered. Charging of fees forms common means of collecting money by government and is its favourite, because it is collected from the public, who perceives it as payment for service rendered.
Fees are a dual vehicle, as it contains both a price component and that of a tax, which for some is a positive tax and for others, a negative. Those who receive services, valued at more than their levied contributions, pay positive tax, whilst those who paid more than the value of the service they received, pay positive tax.
The position is similar, for instance, with social security payments: the same
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Dr. Jack Itzhak Barsheshet, Ph.D. service, purchased on the free market may be charged differently than by the state, which in fact makes such contributions a kind of a fee, and so those who pay high amounts and receive less valued services, pay positive tax, whilst those, who pay less than the priced value of the services they receive, pay a negative tax component. There are also the ‘sophisticated’ fees, such as lotteries, which is a problematic creature in the sense that it does not involve forced payment, but does involve direct consideration, of unequal value in essence. Accordingly, payment for lotteries is similar to tax, used by the government to fund welfare. In fact the use of lottery funds contributes to the widening of financial gaps in society, since most buyers of lottery tickets are of the lower classes, whilst the fruit of the financial investments in lotteries, often benefits mostly the higher ones. Another difficulty is that the division is not going through a democratic process and may therefore be unequal. •
Participation Fee
This is a payment of an amount, levied upon a person which receives a certain service given to him/her by a governmental body. The payment should be relatively equal to the cost of the service. The idea behind participation fee is matching the cost of the service and should not include any hidden tax element, aimed at enriching the entity that imposed it.
•
Municipal (Propriety) Tax
Municipal (Propriety) taxes are commonly calculated against criteria referencing the size of the property held by taxpayers, the value and the number of residents therein. Its purpose is to fund the services provided by the local authority, such as roads, infrastructure, landscaping, social activities and more.
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Dr. Jack Itzhak Barsheshet, Ph.D.
5. Differentiating between sorts of Mandatory Payments
•
The Tests for Differentiation o Where payment is made for service rendered and it is relative in its amount to the value of the service, it is then a price, rather than tax; o Where the amount payable is greater than the value of the service, but there is a link between the service and payment, it is then a fee and not tax; o Where payment is levied upon a certain type of activity, rather than in general, it is a projection or participation fee but not tax; o In all other cases: where there is no link between payment and particular service, or where the basis for payment does not originates from the payer and it is imposed by coercion, it is tax.
•
The Significance of Differentiation
We have already seen that tax may only be imposed by the House of
Representatives, as representative of the people. However, the House of
Representatives may delegate certain powers to other government units, such as municipalities. Accordingly, it may be said that at one side of the scale there is tax, which must be legislated by the House of Representatives, whilst on the other side thereof, is price, which does not require legislation at all. Within those brackets, exist various payments, which form both price and tax and those, having included in them an element of tax, require the government units to be authorized by the House of Representatives before they may be imposed. It is clear that such payments too, are subject to constitutional review.
6. Public Goods
Public goods are defined as goods, supplied by the government, and which has two qualities:
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1) Consumption of such product by one individual does not compromise or reduces the consumption thereof by another individual;
2) No individual may be prevented from consuming the product. For instance, security (a public good of the greatest demand), environmental protection etc. the service provider is the government and payment for the service is collected by taxing. The provision of such services must be undertaken by the government, rather than by the market, because of the existence of market failures.
This is similar to the use of a lighthouse, which everybody may use without fear of compromising others’ ability to use it and which use by another, no one can prevent.
7. Market Failures
This is a term that describes a situation where the market is inefficient in providing a service or product. Market forces do not allocate resources to provide the service or product, because they cannot efficiently do so. Alternatively the term describes a situation where market price does not reflect adequately the costs of production.
By their very essence, public goods invite inherent market failures, where aimed to be provided by the open market. The classic assumption, according to which market forces alone, where sophisticated competition is present, bring the market to an ideal place, will not apply to those products.
Examples for market failures are:
A general market failure known as ‘free riders’: This is a market failure in which some people, seemingly, prefer to forego their need for public goods and avoid revealing their related preferences, because they know that the market will provide
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Dr. Jack Itzhak Barsheshet, Ph.D. such products in any event and that they will be able to enjoy them without paying for them.
Another market failure is called ‘adverse selection’, according to which, provision of certain services by the private sector, will cause it very self to collapse. This is illustrated by reference to the health insurance market, where asymmetry between information, held by insurers, compared with information, held by insured may be found. Where residents are willing to purchase health insurance, those who are at high risk will be more likely to purchase insurance than those with low risk, which will result in insurance rates increasing, to the effect that those with low risk avoid purchasing insurance all together, which in turn, triggers a further rise in premiums, with the effect that those at high risk won’t be able to afford cover either, which will then trigger the collapse of the market. Another example of market failure in a condition of asymmetry is the used car market. In this market, buyers hold incomplete information, compared with sellers. As a result, this necessitates the buyers to assume that cars are of generally poor condition, which triggers a generally lower sale price achieved, than would have been the case in a more sophisticated market.
Another market failure, which involves external influences thereon, is known as
‘externalities’ failure. This involves services or products, which effect extends beyond the personal and direct interest of the service provider or receiver, or the seller or purchaser of the products. At times this involves negative externalizations, such as air pollution, the by-product of the pharmaceutical industry, and at times it involves positive externalizations, such as improvement in the quality of air, associated with oxygen emission, triggered by planting of various plantations.
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Dr. Jack Itzhak Barsheshet, Ph.D.
Another market failure is the ‘moral hazard’, which involves a situation where one may consume products and services, at a lower price than their real actual or perceived value. The average consumer is likely then to consume more than he/she really needs, while he/she is not the one to bear the responsibility to any risk that could emerge from it. For example, when a company ensures itself against theft, the company will make low investment in security. Therefore, the moral hazard causes a distortion in the economic investment of resources and to overvalued services.
An example of market failure in the public service is education: if education was provided by the free market, the recipient thereof would have only seen his own education as an interest and would not have noticed the benefits of education to society as a whole, for which he would also be unlikely to agree to pay voluntarily. The result is that the demand for education will be that education will be offered at a lower price than its real value, which is the total benefit of the personal and general. Beyond that, other, second-tier questions also arise, such as questions of distributive justice, because where education is provided by the private sector, it is likely to be provided differently to the rich and the poor. In addition thereto, this introduces more questions, such as which ‘education’ should be encouraged and funded - whether education in social sciences, engineering, music or perhaps religious studies?
On the other hand, there is also the matter of the converting of public goods with normal ones. Since financially strong groups fund weaker groups, who do not participate in lifting the tax burden, they prefer to incentivise government to provide higher quality and therefore more costly public goods, which is manifested in toll roads or private medical services, which has the effect of reducing the number of available public goods, compared with normal ones.
The more a public good is critical for society, the more there will be tendency to fund it by the relevant funding sector, such as with security for instance. However, the less critical the product, so will the tendency to fund it privately increases, in
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Dr. Jack Itzhak Barsheshet, Ph.D. order to secure a better product at a lower price, which is the result of the market failure of externalization.
8. Incidence of Tax
We have made reference to the distinction between direct and indirect tax, but a distinction based upon these definitions is problematic. Pursuant thereto, any tax may be defined as direct or indirect, for example, where an employee agreed with his employer on net figure in wages, the employer shall carry the burden of tax, which will make it an indirect one, whereas where a gross amount was agreed, tax would have been a direct one. This is also the case where an order is made for a price, which is inclusive of VAT. In this example, the seller will bear the burden of tax and not the buyer. It follows then that the nature of the relevant relationships, the flexibility in supply or demand and the relative strength as between the parties are all influential in determining whether the tax, imposed in any given case is a direct or an indirect one.
There is another ambiguity in this division, for defining direct tax as one, imposed on income and indirect tax as one, imposed on expenditure, blurs the distinction between them, since it is not always clear what is income and what is expenditure and determination sometimes depends on perspective. Therefore it would be better to define maters in the following way: taxation will be direct whenever the assessed tax unit and the taxpayer are one and the same, and is considered indirect when the two may be distinct, for instance, where in a purchase of a product, the consumer in effect fund the VAT, but the liability to pay it to the authority, rests with the seller.
Also, direct tax varies according to personal characteristics, such as income, age, marital status or health, etc., whilst indirect tax does not factor in distinctions between various types of people. Thus the rich and the poor pay the same indirect tax rates, which is attempted to be levelled out, by applying different types of tax to different products, for example, by implementing tax exemptions on basic food
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Dr. Jack Itzhak Barsheshet, Ph.D. and products. Socialist countries will naturally prefer direct taxing, whilst capitalist ones will prefer indirect taxing, on the grounds that it is more equitable, effective, easy, and inexpensive to collect.
It is common to refer to the differences between these two approaches and to politically define them, in the economic sense, as left and right. Tax laws often reflect governments’ views on the political, economic and social issues. Political platforms include explicit reference to tax - social or capitalist, encouragement of traditional or innovative industries, support of different sectors and more.
Discussions over social and economic policy involve reference to those who actually carry the burden of the incidence of tax, i.e., not those who pay it in practice. However, questions of the interpretation of law involve the payment of tax in practice. The central question in tax law is upon whom tax should be imposed. The actual payer will the one who bears the responsibility to pay it, which is the one who will always be taxed in practice and against which enforcement action will be directed. Notably, the theoretical starting point of the incidence of tax is that the burden to pay tax do not lies with the formal bearer of the tax, therefore we should deal with the one who bears the burden of the tax and not the one who bears the responsibility to pay it to the treasury.
We further emphasise the theoretical/economical debate which is focussing on the carrier of the burden of tax, whereas the legal debate involves the taxpayer, and this creates an apparent dissonance between them.
Difficulties arising from the Incidence of Tax
The discussion on the question of who bears the tax burden is problematic since in some alternatives we`ll find one who bears the tax burden and in another alternatives we`ll find another who bears the tax burden. It follows that the character of the one who bears the tax burden varies depending on the circumstances. We will demonstrate it with an example:
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Tax laws impose a tax for corporate profits, separately from the taxing of its owner. Accordingly, where corporations distribute dividends, additional tax is imposed on its shareholders. Imposing harsher burdens on companies does not constitute a problem, because it assumes that those who shall absorb the burden will be the shareholders. The Company may transfer the burden by reducing wages or increasing prices with the effect of preventing the shareholders from such burden, which will thus be partially or entirely transferred to the company’s creditors, customers, employees and others.
This issue is also relevant to discussions on tax benefits - such as tax benefit for those who live in areas of national priority, aimed at incentivising people to move there. In this case, the employee is the one to benefit from the tax benefit. If we assume that in this geographical area there is a low demand in employees along to large employees supply, the wage will also be low in this area. In this case, since the cost of the wage to the employer includes the wages and the tax, then the employees will get low net wage (which contains the cost of the wage of the employees without the tax) and an even lower gross wage (as a result of the tax benefit). The outcome of this situation is that the actual beneficiary is the employer. Accordingly, against all existing arguments with regards to tax incidence, it may argued that parts of it thereof, in practice, is rolled over to other entities, so that the question of tax incidence relates to any discussion, related to tax policies, transforming it to an empiric one, ultimately determined by market forces.
The following is a fascinating example from the field of VAT: in the State of
Israel, when VAT rate increased from 17% to 18%, 2/3 thereof was imposed on the consumer and 1/3 was absorbed by sellers. In contrast, when VAT rates increased by 0.5%, no change in prices occurred and when VAT rates dropped from 18% to 17%, consumers enjoyed only a decrease of 1/3, meaning that sellers took the remaining 2/3 into their own pockets. Accordingly, it would not be utterly accurate to say that the entire burden, associated with VAT, rests solely with consumers, who are the formal bearers of responsibility to fund it, as it may be seen that when VAT rates change, the burden may not be wholly borne by
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Dr. Jack Itzhak Barsheshet, Ph.D. consumers, but rather it is shared in part by parts of the production chain, i.e., it does not roll in full.
9. Principals of a Good Tax system
In his book ‘An inquiry into the Nature and Causes of the Wealth of Nations’ (‘the
Wealth of Nations’, 1776), Philosopher Adam Smith references four principles, required to be present in a tax system, so that it may be regarded as a good one.
These are the golden rules of public policy on taxing:
i.
ii.
Certainty;
iii.
Convenient;
iv.
i.
Basic fairness;
Practicality.
Basic fairness: Taxpayers must be taken into account in the imposition of tax, which must equally be just and fair. This general statement embodies all fundamental principles of justice and equality. It demonstrates that the personal circumstances of each individual taxpayer must be taken into account and that his/her fundamental rights, such as the right to dignified existence, may not be breached by the imposition of tax. Accordingly, the tax system must leave taxpayers and their families with sufficient financial resources, necessary for dignified existence and tax may only be imposed on income, exceeding such threshold. There are those who widen that scope in arguing that tax must not be imposed on amounts, which do not exceed the amount, required for the taxpayer’s intended consumption, which is subject to his/her own discretion (discretionary power to consume). A further argument, derived from the rules of justice, is that taxing would not be imposed for unmaterialised wealth, as this might create a situation where a taxpayer is liable to pay tax for property, which increased in value, where he/she does not have the liquidity to cover such tax, which might force him/her to dispose of other
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Dr. Jack Itzhak Barsheshet, Ph.D. property, just to meet the tax imposition. Such a situation, forms a severe compromise of proprietary rights. ii. Certainty: Tax should be certain and predictable. Tax must be collected in accordance with rules, which are clear and known in advance and not arbitrarily. We have already noted that tax is imposed by force of a social consent and thus, tax levied retroactively may not be subject to agreement, and so it should be known in advance. Retroactive tax legislation is also unjust because people determine their actions with reference to existing tax provisions, and would have perhaps conducted them differently, had they been aware of legislation, potentially affecting their position. This compromises the all-important certainty in business, where tax considerations form a substantive factor in measuring profitability.
Social consent and the requirement for certainty also command that tax legislation be simple and clear. Complex tax laws require interpretation, which by its nature, will differ from person to person and might create discrimination between otherwise equal taxpayers. The demand for simplification of tax rules is not easy to comply with, since tax rules are complex and include legal, financial and accountancy provisions. They are also based on the rapid response to the rapid change of economic activities in the open market. The demand for certainty also relates to another element, which is that tax must not be imposed on income, the realisation, and the extent of which are yet to be determined at the time of imposition. This is yet another reason why states refrain from imposing tax on the increase in value of assets, yet to be realised.
iii.
Convenient: The tax has to be convenient to the tax payer. The practical explanation of this directive is that tax should be close to the ability to pay, both in terms of the amount of tax and in terms of the timing of the imposition of the tax. Tax should be based on fair principles and be close to taxpayers’ ability to pay. Tax must be imposed in a manner that is least offensive to the taxpayer and is just and equal. This requirement and the basis to its implementation triggered extensive writing, which discusses the
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Dr. Jack Itzhak Barsheshet, Ph.D. measure of equality, fairness and justice. It seems agreed by all that the most just measure for fairness in tax systems is that of equality and difference between taxpayers, which requires the development of a measure for the determination thereof.
Since we are discussing economic issues, the correct standards must be those involving financial capability. However, this measure does not reflect the purpose of tax, funding public services, according to which, the right standard should reference the entitlement to public services. It seems that there is a contradiction between these measures, but apparently, they seem to produce similar outcomes, since those with lesser financial capability seem to consume less public service than those of the stronger group. iv. Practicality: Tax must be effective. Simply, the efficiency requirement commands that the cost of the tax mechanism must be low. It cannot be that the cost of tax collection will cost the state more than the revenue taxation generates. This will be a waste of time of the collectors and taxpayers alike.
However, this is a rather simplistic interpretation of this requirement, which is more profound and complex, because efficiency must be examined by tools, taken from theories of public finance and economics.
Effectiveness means that taxing achieves strengthened welfare in general.
However, this stands in contrast of the proven claim that the imposition of any tax creates distortion and change behaviours and therefore necessarily reduces net welfare. Accordingly, this requirement commands that the overall extent of public services provided, must be greater than the injury to general welfare, caused by the imposition of tax. There are however no indicators that can provide data to examine this measure. Some say that perhaps the correct test of efficacy should not be applied to all society, but should rather refer to parts thereof separately. This is because it is possible that certain type of population does not enjoy certain services, which are provided to other portion of society. This requires examination of the rule against such part separately. This raises a fascinating question: whether such part of the population has the right to refuse payment of taxes, paid by other populations.
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Dr. Jack Itzhak Barsheshet, Ph.D.
Some say that in order to measure efficacy, examination must be undertaken of the cost of obedience, such as the cost of book keeping, accountancy, legal advice etc. and also, that tax must not exceed the point, which might encourage taxpayers to evade true tax reporting.
Further Requirements of Good Tax: over the years, further requirements were added to good taxing, which included compliance with constitutional criteria, neutrality in taxing, adaption of the tax system to changes in society and the economy and the use of the tax system in promoting fiscal and monetary policies.
Many states authorise the courts to determine what constitutes good taxing through case law, in the main, in connection with possible injury to constitutional rights, such as: the right to equality, freedom of occupation, the right to proprietary, free choice etc.
10. Neutrality in Taxing
A fundamental principle of tax law is that tax should be neutral to economic processes and to free choice. Free choice leads to fulfilment of personal preferences and this promotes happiness and well-being, and through the
‘invisible hand’ this also promotes aggregated welfare. Tax intervention distorts free choice and thus reduces wellbeing. For that reason, taxing must remain neutral by not causing a change in behaviour. We have however seen that taxing has other purposes, such as ensuring distributive justice, and whilst the two seem to contradict each other, society still prefers distributive justice over efficiency and we will welcome legislation, promoting that cause.
Tax, lacking in neutrality, affects the markets, in that it affects the supply and demand, which in turn injures the efficient allocation of resources in the market because it creates preferences thereto, which are external to supply and demand.
Therefore some stress that neutrality, in the business context, also serves to ensure that business transactions could be undertaken independently, very much as they
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Dr. Jack Itzhak Barsheshet, Ph.D. would have, if no tax was imposed. If the tax system makes it necessary to undertake the transaction in a serpentine way, in order to save tax, then it is not neutral. For example, if taxing of dividends exceeds tax imposed on interest, business owners would prefer to invest in their business, through financial investments - providing the business with a loan or a bond, rather than with a capital investment in capital stock. Consider, for example, a tax system, which imposes tax on inter-corporation dividends. Where a business opportunity arises, which the company planned on funding by use of dividends paid by its subsidiary, pursuant to such taxation, it will surely choose to fund the opportunity by way of a loan, taken from that subsidiary.
The importance of this principle is that healthy economy, present in a developed market, cannot afford a situation where economic processes delay, withdrawn or even transferred to other markets, due to tax considerations.
11. Effective Tax
In discussing taxation, our interest focuses on the tax actually collected, i.e. the effective tax, collected after all market effects and tax planning, which are not part of normative tax structure. Formal (gross) tax is less of an interest to the authorities, although it does have high significance, since the difference between formal and effective tax is the product of implementation of goals that are not inherent to the tax system.
The larger the difference the higher the collection costs will be and the lesser transparency will be. Therefore, common is the argument that in democratic countries, the difference should be low, in order to promote principles of transparency. There should be minimum promotion of goals, which do not serve to fund governmental budget through tax mechanisms. Taxation should be used only where it is clear that the tax system will maximise the generated benefit, although it is clear that in cases in which the state takes with one hand and gives
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Dr. Jack Itzhak Barsheshet, Ph.D. back with the other, there are seemingly unnecessary expenses. We have already said that the use of the tax system to achieve goals that are not inherent to the tax system, introduces a disadvantage of lack of transparency in the distribution of funds, because those are not subject to annual debate and there is no information on the extent of the budget, stemming from such benefits.
12. Efficiency of the Method of Taxing
In examining tax policies, we consider whether the tax system is at an ‘optimal taxation’ level, a concept taken from the theory of public funding. We seek to examine to what extent does the tax system harm economic efficiency and reduces aggregated wellbeing. Another issue, which relates to efficiency is to what extent may tax rates be increased, or decreased and still achieve maximum collection of tax, i.e., what is the optimal tax rate.
The Laffer Curve provides an illustration:
If we impose tax at 0%, then the state will not collect any amount of tax. However, if we impose a 100% tax rate, the state will not collect any tax either, because no one
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Dr. Jack Itzhak Barsheshet, Ph.D. will work. Between these two extremes is an optimal point. On its left, are tax rates lower thereof, which trigger lower collection; surprisingly however, to its right are tax rates higher thereof, but which too, trigger lower collections. It follows then that tax rates, lower than the optimal point, are ineffective and that tax rates higher thereof, are not only ineffective, but are also unjust. The precision of above curve attracted significant criticism, arguing that it's accurate only at its edges, whilst the centre of which is completely random. As indicated, there is no empiric data to confirm or refute the curve or the criticism thereof.
Of course, the political debate between the economic right and left centres around the optimal tax rate. The right wishes to set it to the far left as possible, whilst the left would wish to set it to the far right as possible.
Historical rates of VAT imposed in the State of Israel can present an interesting phenomenon. At first, very moderate rates were imposed, but this tax became to be preferred by the government and rates have been increased time and time again.
However, when the rate was increased from 17% to 18%, there was a decrease in collection. Is it possible to conclude from this that the optimal point of the VAT rate in Israel is 17% or was the decrease in collection due to the economic crisis, in which
Israel was in those years? Once again, there is no unequivocal answer to the question of optimal tax.
13. The Search for a ‘Just’ Tax
•
Progressive Tax
Is a tax system by which the larger the income, the higher the tax rate. Tax is calculated by reference to tables, called ‘tax brackets’.
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For instance:
Income
To
Rate
Tax
Accumulated
from
0
Total
Tax (%)
10,000
10%
1,000
1,000
10%
10,001
20,000
20%
2,000
3,000
15%
20,001
30,000
30%
3,000
6,000
20%
30,001
40,000
40%
4,000
10,000
25%
40,001
50,000
50% (*)
5,000
15,000
30%
50,001
60,000
50%
5,000
20,000
33.33%
60,000
70,000
50%
5,000
25,000
35.7%
(*) above 40,001, the marginal rate of tax is 50%.
Tax brackets are inflexible and apply tax from zero income and therefore clearly contradict the principles of justice. This difficulty is resolved by applying tax credits and tax deductions, as shall be seen below.
Some argue that progressive taxation does not really exist because of the principle of diminishing marginal utility of money and that there is a need to compare the sacrifices, made by payment of tax in each bracket. Those who earn little, pay little too, but their sacrifice is however larger. Those who earn much more, whilst paying greater tax, sacrifice less. The more similar the two sacrifices are, the more equitable
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Dr. Jack Itzhak Barsheshet, Ph.D. the tax rate be considered. With the application of the rules of justice, we are likely to discover that this is actually a relative, rather than progressive taxation. Taxation is proportional to the sacrifice, rather than to income. This achieves effectiveness in the redistribution of wealth in society through the tax mechanism. It is in fact a process of reducing social disparities, rather than one of redistribution of wealth.
There is an argument, by which it is possible to impose relative tax and then balance the outcome by redistribution, through the government's expenditure budget.
However, as we have already noted, redistribution government’s budget in fact forms negative taxing and therefore, there will be no real validity to that chosen method.
However, the power of the government to affect just distribution is weakening, because there are public goods, the consumption of which is regressive, for example, the Homeland Security and the Legal systems, which are available to all, but are being utilised more by the wealthier.
For that reason, it is difficult to replace the role of tax in redistribution through the expenditure budget. The main problem in the question of just distribution involves circumstances in which the poor are so poor, that they do not pay tax at all, which makes it impossible to assist them through the tax system, opposed to via the expenditure budget. In contrast, it is possible to utilise negative taxing to assist the poor. •
Regressive Tax
This is a tax, possessing opposite characteristics to those of progressive tax, i.e., the larger the income becomes, the lesser the tax rate imposed. It is an unjust tax, which offends the poor and that is not common.
•
Flat Tax
Flat tax is a tax that does not depend on the ability of the taxpayer (practically measured by income) and according to which, the rich and the poor pay equally. For
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Dr. Jack Itzhak Barsheshet, Ph.D. example, VAT is a kind of flat tax, as it involves payment of a flat tax rate for all members of society.
Many see neutral taxation as regressive tax de facto. The poor consume their entire income and so, tax is imposed on their full income. In contrast, the rich only consume a part of their income and therefore pay tax only on that part, which they consume. If we compare, for example, two people - one who earns 1,100 and consumes all of it, and another, who earns 100,000 and consumes only 22,000 thereof. Assuming the tax rate of such indirect tax is 10%, we shall find that the poor pays 9% of his income as tax (100/1,100), whilst the rich pays only 2% (2,000 / 100,000) of his income. Since saving is defined as future consumption, eventually all the income of the rich will be directed to consumption.
There are advanced studies, seeking to examine tax neutrality as fixed percentage of income, rather than as fixed amount or in reflection of the principle of diminishing marginal value of money, i.e., determination of the neutrality of tax by reference to income, rather than to circumstances.
•
Tax Credits and Tax Deductions
As mentioned, the tax brackets are rigid in the sense that they apply to all populations without exception, even to those with zero income. In order to ease this inflexible rules, without compromising basic tax rules, it is possible to apply rules, introducing adjustment of tax brackets to different populations, at the stage after due tax was calculated. For instance, adjustments may be allowed by reference to family size or by setting a minimal threshold, which ensures basic existence etc. Such flexing of actual tax payment to be levied is achieved through tax credits and tax deductions.
Tax Credit: is the rate of reduction in the amount of tax due from a taxpayer, pursuant to the provisions of law and tax brackets. For instance, where the state grants annual tax credit in the amount of 1,000 to dwarfs (or students), a dwarf, who earns
20,000 annually, and who should have paid 3,000, pursuant to the above table of progressive taxation, will only pay 2,000, due to such credit, granted to dwarfs.
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Tax deductions: involves the reduction of the taxable amount of income. For example, pursuant to a tax deduction in the amount of 10,000, the dwarf, referred to above, will only pay tax on income of 10,000, i.e., only 1,000. Therefore despite tax imposition starting from zero income tax deduction provides the taxpayer a basic taxfree income.
Tax credits and deductions are part of the normative tax system, as long as they are granted for the promotion of normative tax principles. For example, if the government wants to encourage, through the tax system, the bringing of babies into the world, by introducing tax credit or deduction, then as long as the credits or deductions are aimed at enforcing one of taxing’s fundamental principles, such as the one involving ability to pay, the adjustments will be regarded as part of the normative system, whilst any adjustment, which exceeds this range, will be considered as outside the scope of the tax expenditure (deductible expenses).
Regressive credit and deduction: The deduction provides a benefit, reflected in an amount of tax, which increases as income does. If we compare two dwarfs, one earning 20,000 and the other 100,000 and grant both a deduction of 10,000, we shall see that the benefit to the first dwarf would stand at 2,000, whilst the benefit to the second would stand at 5,000. In contrast, credit is somewhat similar to negative personal taxing and is therefore regressive in nature, in that it is granted to all, regardless of levels of income, thereby violate vertical balancing. If we give a credit of 1,000, granted to both dwarfs, it would mean a benefit in that amount to both, regardless of the difference in their income, which forms a violation of the horizontal balancing principle.
•
Pigovian Tax
Pigovian Tax is named after the British economist Arthur Cecil Pigou and is aimed at dealing with the negative externalisation phenomenon, created when the benefit derived by one from a service or product, negatively affects his/her own consumption
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Dr. Jack Itzhak Barsheshet, Ph.D. thereof, or brings suffering or damage to another person. These negative effects are not reflected in the price that a person pays for the product or service and it is necessary to compensate for such negative externalization, through price and taxation.
An example of such negative effect is where damage is caused by smoke, emitted from a factory pollutes its surrounding environment, or where a factory disposes of its waste in a river, lake or sea, causing their contamination.
Examples of Pigovian taxes are: taxes on fuel, cigarettes, alcohol, vehicles, etc. with all of which, neither the manufacturer nor consumer pay the price for the environmental nor the personal damage caused by use of these offending products.
Pigovian tax increases the cost of the product to reflect the price society will pay in consequence, which may take the form of air purification costs or the price of any other process society is willing to pay to ensure the repair of the damage, as well as the cost of developing an unnecessary health infrastructure for health care system to treat those who suffered direct injury thereby.
This is a market failure dealt with by the introduction of Pigovian taxes, aimed at achieving two objectives: the first is to make the product more expensive and by that to deter consumers from purchasing it, and the other is to raise the necessary funding, required to repair the damage caused to the public in general thereby. Hence, these taxes must, allegedly, go towards funding public transportation improvements, measures to reduce air pollution and road traffic congestion, health, research foundations, addiction treatments and so forth.
The difficulty with Pigovian taxation lies with the ways of determination of the extent of tax that should be imposed and its distribution and in general - if one cannot measure those factors, then it is not right to impose it prima facia. What is the exact amount that one must repay society for causing damage to the environment? It follows that in dealing with the question of the relationship between efficiency and fairness, efficiency prevails and taxes are imposed nevertheless. In this regard, interesting questions arise, such ones, related to customs on cars. Is it correct to say that when a car is stolen, the tax paid for it is stolen as well, or perhaps it is right that the state reimburses the car owner for the tax paid in lieu of the stolen car, because its
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Dr. Jack Itzhak Barsheshet, Ph.D. owner no longer pollutes the air, and why should the state charge customs again for a replacement car purchased, where credit is due on the tax paid for the stolen one…
14. Deferral
Deferral forms tax benefit that may be granted through early application of deductible-tax-expenses (such
as
increased
deducible
depreciation)
or
postponement of income. This forms a tax advantage in that it defers the date upon which tax is imposed, although it does not eliminate it altogether. This is the source of the phrase ‘tax deferred is tax saved’. Where for instance, if payment of tax is deferred, say, for three years, where interest rate stands at 10%, those who deferred payment of tax will ultimately pay a total of 66% thereof and in other words, will have saved one third of the original liability. This is due to the price of money, reflected in the rate of interest. Thus, this concerns the present value of the amount of tax deferred, which serves as a discount in the amount of deferred tax liability. Calculating the difference between present value of the deferred tax and tax capital deferred reflects the tax benefit generated by the deferral.
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Chapter Three – Topics
15. Value Added Tax (VAT)
•
Introduction
VAT is a relatively young tax system. It was ‘invented’ in Germany after World
War I. It is a tax, convenient to collect and difficult to evade and is multi-levelled, in that it is imposed on the added value that businesses create. Technically and simplistically, businesses pay VAT on income, minus expenses, excluding the cost of labour. The deduction in VAT is undertaken, based on a document, produced by suppliers and at the end of the tax chain it is rolled into the pocket of the end-non business-consumer.
In most countries VAT is imposed in addition to income tax and in many, higher
VAT is collected, than income tax. The reason for this is the effectiveness of collection thereof, which stands at over 90% of its potential. Despite this, the world did not withdraw income tax in favour of VAT, because it is a regressive tax, for which the state compensates by using progressive income tax.
•
Added Value
The economy distinguishes between firms (corporations and non-incorporated businesses) and individuals, the income of whom may take the form of profits, generated by the firms, or of salaries paid by the firms. The added value of the firms is their contribution to gross national product (G.N.P.). One of the definitions of national income is any added value, produced by all firms in the economy and the wages they pay. Therefore it is possible to determine approximately, that the added value is the total of profits and wages paid.
For reasons of simplicity and convenience we include in the total value, added by the firms, the value of the wages paid by them. Since thus, salaries form part of overall value added in the economy, ostensibly, employee should be required to
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Dr. Jack Itzhak Barsheshet, Ph.D. pay VAT on their income as well, which in turn will also require a substantive widening of the taxpayers circle, such at a huge administrative expense. This difficulty was resolved by the determination that VAT paid by firms, includes the salary they have paid out.
VAT may be imposed on the basis of the destination of the goods sold, which means it will be imposed on consumption at the geographical location in which the goods are consumed. Therefore exported goods would not attract taxing, which will be triggered nevertheless on imported goods, which in fact forms tax on consumption, rather than value added tax. Conversely tax can be levied on the basis of the origin of the goods, such tax applied to exports and not on imports, which is indeed VAT, but this however is impractical to enforce, because it involves the taxing of foreign entities, rather than of those, subject to the authority of the state. Therefore naturally and for enforcement reasons, countries impose the territorial tax levied on consumption.
Accordingly, it is notable that such tax is imposed on consumption and not on added value in effect.
•
Methods of Imposing VAT
There are different ways to impose VAT. And the following are but a few:
Imposing tax on the first link in the chain: by this option, higher tax may be imposed on the first link in the chain alone, manufacturers or the importers, at an extent, which generates similar amount to those, collected through VAT. This method is convenient, because it involves a smaller number of taxpayers and collection may be secured earlier in the process than otherwise. In contrast, this may deter manufacturers, must already deal with very high initial funding costs, which might in turn highlight to those manufacturers, the advantages of importation over domestic production, which will serve to restrict local growth, as well as an incentive to evade tax.
.
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A single-stage tax on consumption can also be imposed, which means taxing products’ retail price and in other words, imposing a sales tax. Countries, which impose sales tax, exempt therefrom trade and services activity undertaken between firms by applying a zero tax rate thereto, since tax is already off set within the taxing chain. This method is an express sales tax, although the result it generates is the same to the one, generated by the classic VAT system. The difference between the two methods is that with VAT, the burden is divided throughout the whole manufacturing chain, which also means that collection thereof takes place earlier in the process, because taxing occurs before the final consumer-sale point. However, taxing of consumption imposes a heavy burden on a small group of retail firms and thus creates an incentive to evade tax. It is also arguable that sales tax is levied on turnovers, regardless of the actual generation of profit, or the lack thereof.
Multi-stage sales tax: this involves imposition of a low rate of tax on each stage without allowing the deduction of tax paid by firms, so that in aggregate, the state collects the same amount of tax. The drawback to this method is twofold: firstly it is a tax imposed arbitrarily, without reference to added value. Theoretically, it is possible that a firm is levied with tax, which in itself exceeds the firm’s added value in its entirety; secondly, adding a new factor to the tax chain will cause different taxing on different products, simply by reason of the mere number of firms in the chain. This is an unjust, un-neutral and ineffective tax, because it might cause firms to attempt to reduce the number of stages and inevitably will not encourage specialities, which is the lifeblood of modern technological progress. •
Further Problems with VAT
Modern economic concepts see this tax as a fiscal tool, since it affects consumption. Raising tax rates reduces consumption and might curb inflation. On the other hand, lowering tax rates leads to increase in consumption, and thus, to economic growth.
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The VAT system is simple and uniform, and as a result it does not raise substantial theoretical questions such as justice, redistribution, etc. There are countries in which multi-stage VAT is imposed, or where exemption is granted on certain types of goods, such as medicines, children's clothing, bread, and so on.
Un-uniform tax rates increase the costs of the administration of its collection and cause distortions in the classification of products. Producers and marketers will attempt to classify the products they sell as exempt from VAT, thereby reducing tax liability. For example, questions will be raised of what is medication, what includes children clothing or what is bread.
•
Battling VAT Evasion
The temptation to evade VAT is essentially found in the last link in the chain, the one which is contact with the final consumer. It occurs mainly with retailers, coming in contact with the consumer, who cannot deduct the tax paid, but not only that; VAT in its classic form operates in a way that each link in the chain, issues a special certificate to the buyer, which serves as kind of a financial cheque that allows the buyer to reduce the amount of tax it pays, by the amount of VAT, reflected in that document. Temptation to ‘purchase’ such certificates or forge them is substantial and tax authorities are fighting that disease.
There are various methods to combat this disease. There are countries that issue
VAT certificate for the firms, so that tax authorities can keep track of documents and ensure that the firm, deducting tax, stands opposite the actual person who has paid it. There are countries that require firms to issue a VAT certificate before actually providing the goods and a copy of the certificate is required to be delivered in real-time internet communication to the tax authorities. Another method is the transmitting online current lists of all certificates of income and expenditure, which are accompanied with periodic reporting to the tax authorities.
Tax IT systems can compare documents, provided by all firms online and identify
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Dr. Jack Itzhak Barsheshet, Ph.D. those who under or over report (the tracking in this case is preformed only with the presentation of the online periodic reporting).
•
Tax Regressivity
Value added tax at a flat rate on consumption is regressive in nature because the percentage of income, spent on consumption decreases, the higher the income and the percentage of tax increases, the smaller the income. In order to reduce regressivity, some countries have set different tax rates for different goods, mainly reducing tax rates, even to fully exempting basic necessities, such as medicines, and even children's clothing. These products are consumed mainly by financially vulnerable populations.
Since VAT is a regressive tax and income tax is a progressive one, the two offset, but only to form relative taxing. We have already seen that taxation is relative to income, operated pursuant to the principle of diminishing value of money is a regressive tax. Therefore income tax has to be progressive twice: firstly to undertake the redistribution of wealth and secondly to cancel out the regressivity of VAT. But this would not suffice to provide relief to the poor, who do not reach the stage of triggering tax liability.
In federal states, the particular problem of imposing state level taxes, as well as federal tax arise. When it comes to the distribution of VAT collected between the state and the federal government, it is difficult to determine entitlements accurately. Division must be determined politically and by agreement. In
Germany for instance, the matter was resolved by agreement, but in the USA, no agreement has been reached and thus, each state applies its own rules. The result was the imposition of sales tax (rather than consumption tax) in most, but not all states. Sales tax is simply and is imposed at the place the product was purchased, rather than where it was consumed.
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•
Tax Exemption as opposed to Zero Tax Rate
Countries can encourage or lower the burden of tax for populations or areas by
VAT exemption. This method of relief may be undertaken in two ways:
In imposing a zero tax rate, tax was imposed, but the rate of which is zero. This means that firms will be allowed to deduct the tax they pay to suppliers, but will pay zero tax on their income. The significance in applying this method is in that it lowers the full burden of the tax entirely for the benefit of the entire chain.
Tax exemption is another method, by which, the firm does not pay tax on its exempt income, but it is neither entitled to deduct tax paid to its suppliers. It thus follows that the benefit in this case is only the amount of tax on the added value of the last firm in the chain.
• VAT and Non-profit organisations
We have already said that added value is formed by corporate profits and the wages they pay. Non-profit organisations do not operate for profit, so we may assume as a working hypothesis, that they have no net income and in turn, their value added is only formed of the wages they pay. If that is the case, taxation of
Non-profit organisations can be undertaken by imposing tax on the wages they pay, at a lower rate than the rate of VAT levied on firms. This is aimed at factoring in the tax paid by Non-profit organisations on their expenses, which they may not deduct, as opposed to firms. Alternatively, it may be argued that transactions, undertaken by Non-profit organisations are exempt of tax, and anyway they cannot reduce their tax liability by deducting the tax on their expenses. So with the assumption of no profit making, those organisations are taxed at a lower rate and only on wages.
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16.
Accountancy and Definition of Taxable Income
Accounting is the language of reporting on the results of business operations and on the financial position of the firm. Its goal is to report uniformly to all parties with an interest in the financial reports: owners, creditors, the authorities and the public.
Accounting is the method by which firms’ income is assessed and true assessments on their financial condition is made. This is undertaken by reference to periodic financial reports, which include the following:
Balance Sheet: in which information is given on the entirety of the firm's assets and debts and the difference between them, which forms the firm's equity true to the day in which the balance sheet has been prepared.
A statement of changes in shareholders' equity: as its title suggest, shows the additions and decreases, during the period, of equity of the firm.
Profit and Loss Statement shows a breakdown of revenues, expenses and the difference between them, which forms the profit or loss for the period.
Cash Flow Statement: reports on the use and origins of cash over the period, taking as a starting point, the amount of cash at the beginning of the period and details the movement of cash during the period: their origins and their uses, and ends in the cash balance at the end of the period.
Notes: are details of verbal and quantitative nature, add important information that is not listed in numbers in the reports abovementioned, such as: details on the accounting policies upon which the reports were prepared and changes to this policy, details on the amounts listed in the above reports, but which are not accessible therefrom only, as well as any information that could add to the information contained in the reports, and which the accountants consider is
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Dr. Jack Itzhak Barsheshet, Ph.D. necessary in order to comply a full and accurate picture of the state of the firm and the result of its activity.
The reports are prepared by reference to internationally agreed upon principles and the following is a list of the more important ones:
The Conservatism Principle, by which reports will only detail profits actually achieved and expenditure predicted on high probability basis and thus, income, which is only expected and holds no substantive degree of certainty, will not be reported. The reports are prepared by management for the benefit of the shareholders and are aimed at providing a cautious report on the profits, made by the firm over the reporting period.
The Cost Principle involves all money transactions being recorded objectively, according to the historical cost at their date. This principle weakens during periods of inflation and there are countries in which the financial reports are prepared in accordance with the historical cost, subject to adjustments originating from inflation indices. This keeps the objectivity of the report on the one hand and on the other, provides current data.
International Financial Reporting Standards (IFRS) are international accounting principles, aimed at assessing the assets, contained in financial statements at their fair value, by presenting the firm as much as possible in real terms, according to expert appraisals.
The Matching Principle, according to which the income should be matched to the expenses and both, should be matched to the reported period. Thus, reported in the statement shall include all income over the period, and the expenditure reported shall include all expenses over the period, only which were expended in the process of making the income reported.
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Tax authorities in most countries accept these accounting principles for determining taxable income. They still however remain undecided on applying the
IFRS rules to their respective tax systems, because such application would dramatically change the manner in which taxable income is determined. Tax authorities have yet to digest the empirical implications of implementing these rules on tax collection, and changes in the methods for determination of income by way of application of these rules, may be expected in the future.
17. Taxing International Activity
•
Introduction
Not all income is naturally taxable in a taxpayer's country of residency. In order to tax, a link is required between the source of the income or the taxpayer and the taxing state. Thus there may be two tax jurisdictions: a territorial connection, i.e. the location of the source of income, the income generating process and its production and a residential link – determined by the characteristics of the taxpayer and its relationship to the state.
It is clear that state A cannot impose tax on the income of a resident of state B on income produced in state B or state C. State A’s taxing system may tax persons from across the world, who generated an income in state A, and may tax its own citizens for income generated in State A, B, or even C. For that reason, a resident of state A would be liable to pay tax at the state in which his/her taxable income was generated first, be that B or C, and will also be required to pay tax at his own state- A.
If so, such person is expected to pay double tax on income, originating in state B or C. International taxation therefore, involves two issues: upon which international income and to which taxpayer do local tax laws apply and how may prevention of double taxation be achieved?
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•
The Territorial Tax Method
This method of taxation imposes tax on income, generated within the territory of the taxing state, regardless of the place of residency of the earning entity. Tax is thus imposed on all income generated in that country, whether by its residents or otherwise. Of course, countries, the main of which produce is local, will prefer this method of taxation. It is also a fundamental and worldwide acceptable principle in taxation, that each state is entitled to impose tax on income generated, accrued or received within its territory by any person, being the ‘country of origin’. Since the purpose of tax is to fund the budget of the state, which makes available to anyone who generates an income in its territory, public services, as well as its infrastructure for their operations, it is appropriate that those who generate an income within its territory, contribute towards its budget. The state provides its residence, as well as to foreign residents who invest in business in its territory, protection over property, a legal system and policing, providing personal and property protection, which services are used by such foreign residents. According to the principle of benefit and burden, such services must be paid for by tax.
This method originates in the late 19th century and is known as the 'economic allegiance'. There is another method, known as ‘the force of attraction’, pursuant to which all international economic activity, which originates in the country of origin, but which is generated in consequence of that resident’s main activity, which takes place at his/her country of residence, shall be taxable by the country of residence, despite the prevailing method of taxation as a territorial one.
On the other hand, in a global village world, it is easy to disguise income as attributable to a country, which imposes low taxes. For instance, a web server selling goods (such as eBay) can be moved to any country and thus avoid the imposition of high tax rates to its owner, let alone where the server is owned by a foreign company. It is clear that mobilising the server to a tax-less state, will result with zero tax payment where territorial taxing rules apply and it is perhaps too
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Dr. Jack Itzhak Barsheshet, Ph.D. easy and simple to evade tax in this way. This may be solved by taxation according to different principles, such as the method of residential taxation.
•
The Residential Tax Method
Personal taxation does not necessarily exist in all taxing systems and is used in addition to the application of the territorial tax method. This method imposes tax in reliance of taxpayers’ residency, regardless of the place of generation of the income, that is, regardless of whether or not the income was generated in the country of residency. It is therefore clear that exporting countries, which are the home for owners of a large number of overseas companies, will prefer this method of taxing. This has been the choice, for instance, of the British Empire, reflecting its will to collect tax from all its residents, for their activities around the world.
A foreign citizen, who resides in a country that applies personal taxing rules, will be required to pay tax, firstly, to the country of origin (source of income) and only then to his country of residency, as we have already discussed the principle that the country of origin takes precedent over the country of residency to impose tax on such income.
There are also rules that regulate matters of corporate
residency because otherwise, a person could easily establish corporation in a lowtax country and route all his/her income from outside his own country thereto, thus avoiding tax.
•
Relief from Double Taxing
The personnel tax system presents a number of problems, the most substantive of which is double taxation, which may be solved in two ways:
Domestic legislation: domestic law may make provisions to the effect. Either any tax paid to the country of source shall be deducted against the full local tax liability, or that taxing of the income, generated at the other country shall be calculated, deducting the amount of tax paid at the other country as an expense.
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Dr. Jack Itzhak Barsheshet, Ph.D.
International agreements: agreements between countries of residence and countries of origin, which regulate tax liability on income generated in others countries and divide the tax pie between them. These agreements regulate the issue of double taxation in various methods and are referred to as ‘double taxation treaties’. Domestic tax laws rules give effect and determine the superiority of the treaty over domestic law.
Parenthetically, we point out at the outset that there are many questions, arising from international taxation. For example, there could be dispute between two countries about the residence of particular person. The two countries will seek to make him/her a resident of their own and he/she will remain at the centre of the conflict, powerless to influence it. The conflict stems from the will of each of the countries to impose tax on the ‘resident’, without having to allow him/her credit on the tax, already paid to the other country.
It would have been expected that the countries of the world, through the UN, would formulate a unified global treaty to prevent double taxation however, such tax treaty doesn`t exist and most treaties are bilateral. Models of existing treaties are the American model, imposed by the Americans in any treaty which they are a party to, and the OECD model. The European Union is trying to formulate a treaty of its own, but without much success to date.
It is important to reiterate the primary tax entitlement, given to the country of origin, but it is not always clear which is that country for a particular income and it is possible that a taxpayer is levied with tax in both countries, claiming primacy entitlement. It is of significance that only the country of residence can allow credit on tax paid to the country of source and where both countries claim primacy, taxpayers may pay double tax. It should also be emphasised that tax credit may only be allowed in an amount of tax to be paid to the country of residence and so, it will always be the case that taxpayers pay the higher tax of the two countries.
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
There are countries, which go even further and determine tax credit by using the
’income basket system’, where a basket may refer to a type of income, or country. According to this system, tax is calculated for each basket separately and credits are allowed with reference thereto only. Thus, it is possible that a taxpayer be in credit by one basket and in debit by another and an offset would not be permitted, to the effect that full tax is paid where due on any of the baskets.
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Issues in International Tax Planning
As in any other area of tax, in international taxing too, taxpayers make use of laws for purposes of tax planning. In international tax planning, reference is not only made to domestic legislation, but also to tax laws of other countries, and of course, to double tax treaties. The following is a brief review of some:
Use of Corporate Entities: as mentioned above, a person may establish a company in a low tax jurisdiction and direct all his/her international activity thereto, thus avoiding tax on such activity, until profits are shared as dividends. In order to tackle this difficulty, countries around the world legislated provisions, generally known as the CFC rules (Controlled Foreign Corporation), according to which, the profits of a foreign company, owned by a resident of the state but registered in another jurisdiction imposing lower taxation (such lower tax rate is usually slightly lower than the corporate tax rate in the country of residence), shall be regarded as dividends, distributed to shareholders, resident in the state.
Treaty Shopping: this kind of tax planning is based on tax benefits contained in tax treaties, agreed between countries. To take advantage of such treaties, companies are established in countries party to the treaties in order to take advantage of these tax benefits.
For instance, a resident of country A wishes to establish a factory in country B, where taxing on such factories and on dividends is low, say, for purposes hereof, zero%. Such a person would pay tax on the company’s earning at country B first,
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. and only when the company distributes dividends to him/her, there will be created tax liability on the dividends at country A
Suppose that country C is a party to a treaty with country B, which exempts its residents from tax on dividends distributed between companies of different jurisdiction. Suppose also that country A has a similar treaty with country C. For that reason, the resident of country will establish a company at country C, which will in turn establish a company in country B and which will purchase a real estate property for purpose of commercial letting. This way, no tax will be paid for the rental income at country B and no tax will be paid on the dividends, distributed between the company in country B to the company at country C, as well as on the dividends, distributed between countries C to A.
Such tax planning is tackled by domestic legislation and by application of the treaties. There is quite extensive case law, developed by the courts in many countries, which formulated the principle known as the ‘equitable owner of income’. According to this rule, all artificial foreign companies are ignored and the company, established in country C, shall be regarded as a resident company in country A, the country of residence of its shareholders.
Transfer Pricing: If a resident of a country is the owner of a number of companies, each in another jurisdiction, for instance, a pharmaceutical company, which owns an R&D laboratory, which also owns IP over a drug patent in one country, a pharmaceutical factory in a second country and a marketing company in yet a third country. Such person would wish to attribute royalties, due to the company holding the IP rights from the company of the owner of the factory, as a function of tax rates in both countries. This would also apply to the sale price of the pharmaceuticals, sold by the factory to the marketing company in the third country. If we assume, in the extreme, that the manufacturing company is exempt from tax by the second country, it will prefer to avoid any payment of royalties to the IP
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. holding company. It will also prefer to sell the medications it manufacturers to the marketing company at a price, similar to their price at the third country. This way there would be no taxable profit in any of the countries, which impose tax (the IP and the marketing countries) while all profits were redirected to the country, which applies the tax exemption (the manufacturing country).
This issue is resolved by reference to the transfer pricing rules, which essentially take the form of domestic legislation, regulating fair pricing in transactions between related parties and companies. Thus, such rules will prevent the chance of non-payment of royalties and will determine the right price for the pharmaceuticals at the marketing country. In other words, transfer pricing rules are a complete theory, consisting of many models, which regulate the manner in which profits between related companies are shared.
Mishap: A true incident, which occurred in India. A pharmaceutical company, which applied unrealistic transfer prices, and so directed her profits to a low-tax country, was assessed with tax differentials worth billions of dollars, which was supported by the local Supreme Court. The company paid low tax over the income, redirected to the low-tax country, but was forced to pay tax over the same income in India as well.
E-commerce: what happens when commerce is undertaken by computer and the product is non-tangible and is provided over the internet? We add that the server is located at one country, the buyer in a second and the seller in yet a third, the company, which owns the server is located in a fourth country, the bank account of the company in a fifth country and its shareholders are residents of a sixth country. Which country should be allowed the first bite of tax? Which is the country of origin and what tax rules should be applied in determining tax in such an instance?
Encouragement of Economic Activity through Tax Exemption to Foreign
Investors: This is the place to note that sometime, tax exemption is merely a
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. governmental stupidity. For instance, a country, which exempts tax over the renting of residential property, aimed at attracting foreign investors in the field.
We assume that the investor will be liable to pay tax in his country of residence on his/her income from such letting, although he invests in the country of origin. The outcome is that instead of tax being paid in the country of origin, it will rather be paid at the country of residence. If tax was applied at the country of source, at a rate, similar to the rate, applied at the country of residence, the investor will have paid the very same amount, but, to the country of origin. Stupidity!
18. Corporate and Shareholders Taxing
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Introduction
A company is defined by law as an accumulation of contracts. In other words, the mere existence of a company is depended upon a contract between itself and the public, additional, its activity is sourced in contracts. The company itself cannot enjoy the public services provided by the state; those who do enjoy them are its shareholders. This matter raises a number of theoretical questions, dealing with corporate taxing and its justification together with the manner and extent of imposing corporation tax.
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The Justification to impose Corporate Tax
Economically, a company is the extension of its shareholders, who serves them to maximize profits. The company itself does not use public services, nor does it consume. Income is defined as consumption plus savings; since savings actually is future consumption, it follows apparently, that companies have no income.
Though, all countries impose tax on companies. The question that arises here is whether the company, which is merely a channel for the transference of revenue to its shareholders, should be taxed independently, or should its shareholder be taxed directly. 59
Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
Theories on the imposition of tax and on distribution of the burden of taxation are not compatible with the corporate model, but are compatible with the model of taxing its shareholders, only through which it is possible to implement the rules of justice, of equality, of ability to pay and others. With reference to indirect taxing, the company itself does not consume and for that reason, it will not be imposed with consumption taxes. For those reasons, it is necessary to choose between the legal concept of separation between the company and its shareholders and the economic viewpoint that the company is a conduit for its shareholders’ wealth.
Justification for imposing Corporate Tax is based, among others, on the following arguments: Tax should be paid for the protection from liability which the law provides the shareholders; reducing the market failure known as ‘moral hazard’
– the separate liability between the corporate and the shareholders, leads to excessive risks that the results of which are laid upon the public, and by imposing tax the damage that derives from them will be reduced/moderated; using tax to limit the power, possessed by giant corporations, that have an extended influence on the economy; there is also the "agent issue" by which there is a different interest between shareholders (the transmitter) and the CEO`s (the delegates).
Taxation may somewhat dull the inherent conflict between them.
Answers to these and other questions will determine what tax system should be applied, as tax may be imposed in a variety of ways. The scale moves across the range, from the double taxation model to the full transparency model. There are those who believe that companies should pay tax separately from their shareholders, but they do not take into account that the payment of tax by the company reduces its resources to distribute dividends to its shareholders, which means that tax is indirectly paid by the shareholders. Therefore, this form of taxation operates as double taxation and thus violates the rules of justice.
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The Full Transparency Model
According to this model, tax is imposed by reference to the economic reality and not according to legal rules. For taxation, the financial position of the company is
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. transparent, and the tax will be levied upon each of its shareholders, according to their respective marginal tax rate.
This model is found in most of the world in taxation of partnerships and in several countries, on a voluntary basis, in corporate taxing. We can find some differences between the two; usually the assets of a partnership, as well as its revenues, belong to its partners directly. However in transparent companies, all assets and revenues belong to the company itself and only the ‘bottom line’ - the profit, is attributed to its shareholders and for that reason, the Full Transparency model exempts dividends, distributed by a transparent company. For this reason, this model can be successful where there is a small number of shareholders and where their substitution occurs rarely.
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The Double Taxing Model
According to this model the company pays tax according to a corporate tax rate, whilst its shareholders pay personal tax according to their marginal income tax rate. Suppose for example that corporate tax is 25% and that its shareholder’s marginal tax rate, which is equal to the maximum marginal tax rate applicable, stands at 40% and that the income stands at 100,000. In such a case we shall see that the total tax on the income will be: 25,000 paid by the company and 30,000 tax will be paid on the remaining 75,000, so the net income will stand on 45,000.
That is to say that the overall tax will be 55%.
Clearly, in such a case, no tax-payer would have an interest in operating through a company and therefor, in order to encourage commercial activity through corporates, tax should be imposed at a total rate, which includes both corporate tax and shareholders’ personal tax, not exceeding the maximum marginal tax rate.
If we take the above mentioned example and change the rate of tax on dividends to 20%, the overall taxing would stand at 40,000, i.e. at 40%. This rate is the same as the maximum marginal tax rate. This is the break-even-point. However, this still does not resolve the issue, arising from the taxation of those whose marginal tax rate stands below of the maximum marginal tax rate.
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D.
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The Corporate Value Model
According to this model, the value of the company’s shares is assessed and the increase in their value is calculated. In order to determine the taxable income, any dividend paid to the shareholders that year is added to that value and the overall result would be taxed at the respective marginal tax rate. This model has several disadvantages: it relies on assessments and it is applicable only to companies, which shares are traded in a market. We have already mentioned another point, which is that imposing tax on value is unjust, because it may result in a situation, where a shareholder must sell part of his shareholdings, in order to fund his/her tax liability, which violates the good tax rules.
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Other Methods – Partial Interlacements
We have seen that the various methods of taxation seek to generate one method, which will combine all rules of equality and justice, horizontal and vertical. Some prefer that companies bear the entire tax liability and that dividends will be tax exempt. This method inherently imposes a maximum marginal tax rate, which causes the tax imposed to be unjust. Another method considers that tax should only be paid when dividend is distributed. The rate thereof should be the shareholder’s marginal tax rate. This method has its flaws as well, because it ignores the reasons for which tax should be imposed on corporations and it also defers the tax payment date to the date upon dividends are distributed – an obvious and unjustified tax benefit.
There were many attempts to identify the right method of corporate taxing and their shareholders, but only one, which considers corporate taxing as an advance on the tax due by their shareholders may achieve the goal. It is a method of partial integration and according to this model, corporate tax is imposed on the company, but its dividends distributed shall be considered as deductible expenses and will be applied with negative taxing. Thus, at the time of distribution of dividends, the company will become entitled to reimbursement in tax in the value of the dividend
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Rudiment Principles in The Theory of Tax
Dr. Jack Itzhak Barsheshet, Ph.D. distributed times the corporate tax rate, but its shareholders will pay tax in accordance with to their own marginal tax rate.
We will demonstrate: a company has an income of 100,000 and it paid corporate tax of 25,000, it has a sum of 75,000 left of profits to share. If it distributes
75,000 in dividends, it shall become entitled to a 25,000 tax refund, in other words, to conclude, it has the possibility to distribute a dividend of a total of
100,000. If so, at the moment of the actual distribution of the dividend, the company will have a tax refund of 25,000, while its shareholders will have to pay tax in accordance with their marginal tax rate. If we assume that the marginal tax rate of the shareholders stands on 30%, then they will have a tax liability of
30,000 and the company will have a tax refund of 25,000- if we can set these sums off then according to this method the shareholders have to pay only 5,000. The outcome is that taxing the entire sum of the dividend distributed at the shareholders’ marginal tax rate, together with the refund of the tax that the company paid on this sum leads to justice taxation.
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