A Primer on Tax Policy: Part 1 by Denvil Duncan*

Abstract

As Jamaica navigates the current economic climate, its leaders must pay careful attention to tax policy design and implementation. Tax policy can be difficult to design and its effective implementation can be even more challenging. However, there is over 200 years worth of knowledge regarding tax policy design and implementation that can be used to make this task a bit easier. This series of essays provides an introduction to tax systems through the lens of a public finance economist. The series begins with outline the main features of tax systems. This is followed by a detailed description of the characteristics of a ‘good’ tax, and a discussion of implementation strategies. The discussions will include numerous references to Jamaica’s current and proposed tax policies. The primary goal of the essays is to get Jamaican voters up to speed with some of the key concepts required to critically review current and future tax policy proposals.

*Contact Information: School of Public and Environmental Affairs, Indiana University. 1315 East 10th Street, Bloomington IN 47405. Email: duncande@indiana.edu; Phone 812-855-7493. Website: https://sites.google.com/site/denvild/Home

 

Features of a tax system

Every tax system has three core features. Below I describe each of the three features.

Tax Trigger.

The tax system must specify the set of actions that trigger tax liability. This component also includes a precise definition of the tax base and the tax rates. Consider the personal income tax, for example, actions that trigger tax liability include working or investing; the tax base is labor earnings or investment income less any deductions or exemptions. The tax rate schedule can either be linear or graduated.[1]  A linear rate schedule is one that has a single rate that applies to all taxable income. For example, Jamaica has a linear tax rate schedule; everyone pays a tax rate of 25% on their taxable income.[2] A graduated tax rate schedule is one that has multiple tax rates that each apply to different tax brackets (see Table 1 below).

 

Now, let’s illustrate how these two types of tax schedules work. Suppose your taxable income is $50,000, then:

  • A linear tax schedule would tax the full $50,000 at the same tax rate. So, if the tax rate is 25%, then your tax liability is $12,500 (=50,000*0.25).
  • A graduated tax rate schedule would first divide your total taxable income into parts that match the tax brackets, and tax each part at the corresponding tax rate for that bracket. Let’s use the schedule in Table 1 to illustrate. Because there are three tax brackets, you would first divide your $50,000 into three matching brackets. The first $20,000 of income is taxed at 10%. The second $20,000 (the amount between $20,000 and $40,000) is taxed at 15%, and the remaining $10,000 (the amount between $40,000 and $50,000) is taxed at 25%. In this case, your total tax bill is $7,500 (=$20,000*0.1 + ($40,000-$20,000)*0.15 + ($50,000-$40,000)*0.25). Notice that this tax liability is lower than the one above because of the specific numbers used in the examples. It is very easy to chose values that would cause the graduated schedule to yield a higher tax liability than the linear schedule.

 

Table 1: Graduated Tax Schedule

Taxable Income Marginal Tax Rate
Less than 20,000 10%
20,001 –  40,000 15%
More than 40,000 25%

 

Tax Burden

The tax system must specify the allocation of statutory and remittance burden. Let’s take on these concepts in turn.

  • Statutory burden. The statutory burden of a tax refers to the person on whom the legal obligation to pay the tax falls. For example, the personal income tax liability falls on the income earner. The general consumption tax liability falls on consumer. Notice that the government can assign the statutory burden of the tax to the seller rather than the consumer. Similarly, the government can impose the statutory burden of the income tax on the employer rather than the employee.
  • Remittance Burden. Every tax system must also specify the person legally responsible for handing over the tax payments to the government. For example, the pay as you go (PAYE) component of the personal income tax is collected monthly by your employer, and your employer is then legally responsible for paying this revenue over to the government. In other words, the remittance burden of the PAYE falls on your employer.
  • Here is another example: consumers are legally required to pay general consumption tax. This implies that consumers face the statutory burden of the tax. However, the seller is legally responsible for collecting the tax from the consumer and remitting said tax revenue to the government. So, the statutory burden falls on the consumer, but remittance burden falls on the seller.
  • Economic Burden. We have long recognized that a tax does not stay where it is placed. For example, a tax on gasoline does not necessarily fall on those who buy gasoline. Because of this, it is important to identify what is called the economic incidence or economic burden of the tax. Let’s illustrate with a tax on gasoline. Suppose the government increases the gasoline tax. What do you expect will happen to the price of gasoline? Also, what do you expect will happen to the price of goods and services that are heavily reliant on gasoline? A reasonable response to these two questions is that prices will rise. The price of gasoline increases so that the economic burden falls on consumers of gasoline.[3] But, it doesn’t stop there; producers who rely heavily on gasoline as an input to their production process will respond by raising the price of their goods and services. Consider for example, a taxi driver. He has to buy gasoline, which is now more expensive because of the tax. He will respond by raising the taxi fare he charges. This then shifts the tax onto people who rides in his taxi.[4]
  • Now, the extent of the shifting depends on how responsive consumers and suppliers are to price changes. For example, the demand for gasoline is generally unresponsive to price changes because there aren’t many alternatives; people have to move between places and doing so requires energy, which is almost exclusively gasoline. Because of this, sellers can increase the price of gasoline without much impact on quantity demand and hence profit. As a result, we would expect to see gasoline prices increase by approximately the full amount of the tax. It might not increase by the full amount if there is robust competition among gasoline sellers. The amount of the increase in taxi fare is less clear. It is less likely to increase by the full amount of the tax because there are more options for consumers; e.g., you can take a bus instead of a taxi. So, not only do you have competition among taxis, but taxis have to compete with other modes of transportation. What this means though is that price will rise, but not necessarily by the full amount of the tax. The degree of the price increase will depend on the responsiveness of demand and supply.
  • To summarize, while the statutory burden falls on gasoline consumers and the remittance burden falls on gasoline sellers, the economic burden is borne by
    • gasoline consumers,
    • people who consume goods/service that rely heavily on gasoline,
    • gasoline sellers, and
    • people who produce goods/services with a high gasoline content.
  • The important thing to know about the economic burden of a tax is that it cannot be legislated. The government can specify the statutory and remittance burdens, but it cannot specify the economic burden; only the market can do that via changes in prices.

Enforcement

Finally, the tax system must specify an enforcement strategy. How many tax returns will be audited? How will the audit selection process work; i.e., how do we determine which tax returns to audit? Is audit selection random or does it depend on the characteristics of the taxpayer? What is the penalty for evaders?

 

The enforcement strategy is an exceptionally important piece of every tax system because most people would rather not pay any taxes. This is especially true in developing countries where corruption is rife and the connection between taxes paid and goods/services received is unclear. Additionally, countries that are heavily reliant on cash transactions and have a large informal economies are prone to tax evasion. The government has to implement an effective enforcement strategy in order to improve tax compliance. This starts with designing taxes that are simple and that provide very little incentive to cheat.

[1] It is not uncommon to hear people refer to the tax rate as being progressive. This is not accurate. The tax rate is either linear or graduated, and either of these can give rise to a progressive or regressive tax system. So the correct description is as follows: the tax rate schedule is linear or graduated while the tax system is progressive, regressive or proportional.

[2] This will change with the proposed tax policy that was tabled in the recent budget presentation by the Minister of Finance.

[3] For example, suppose gasoline is currently sold at $2.00/gallon and the government adds a tax of $1.00/gallon. If the price of gasoline increases to $3.00/gallon after the tax, then it means that the full amount of the tax has been shifted to consumers of gasoline. Suppose instead that the price of gasoline only increases to $2.50. In this case, only half of the tax is shifted to gasoline consumers; the remaining half is borne by the seller of gasoline. So while the statutory incidence on consumers is $1.00, the economic incidence is only $0.50.

[4] So if a $1.00 tax is placed on gasoline and this causes the price of gas to increase by $1.00, which then causes tax divers to increase their taxi fare by $1.00, then the tax has been shifted to the taxi riders.

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