Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples

1 year ago

Atiqur Rahman

12 minutes

Equity Principle of Taxation:

The actual burden of different forms of taxes does not necessarily depend on whom the tax was levied in the first place. According to the equity principle, the tax burden should be distributed equally in society. In other words, it should be fairly distributed among taxpayers. In order to fulfil this criterion of equity, a person should be asked to contribute either according to the benefits received from the payment of taxes or according to the ability to pay.

The benefit and ability-to-pay approaches are two principles of tax fairness used to justify a tax’s fairness.

The benefit principle assumes a contractual relationship between the state and the taxpayers. The contractual relationship emerges from the fact that the state provides certain goods and services to the taxpayers, which in turn help in financing these provisions by paying taxes in proportion to the benefits received by them.

In other words, according to the benefit criterion, people pay taxes in the form of the price of goods and services provided by the government to society; they should pay according to the benefits received in terms of using these goods and services. These benefits received may be direct or indirect in nature, but both should be counted towards calculating the tax liability of a person.

Thus, it argues that the burden of taxation should be borne by the people in proportion to the benefits received from the state. The persons receiving greater benefits should pay more in the way of taxes as compared to those receiving less benefit. In essence, it follows the market principle- the recipient of the benefit of a good or service is liable to the tax in order to maintain the supply of that good or service.

The benefit principle leads to a more efficient allocation of resources as those programs would be given preference for which society is ready to pay more; hence, funds would be invested in high-priority programs, but it also suffers from the problem of free-riding. This problem exists as any person can reduce his tax liability by under-reporting the benefits derived from the state activities.

It is further believed that there is an inherent motivation for paying taxes under the benefit principle, as people know whatever they pay will be used for their benefit. But it is, in fact, a strong assumption. Members of a society derive benefits from state activities according to their demand patterns, which, in effect, depend upon the existing income and wealth distribution. Therefore, this principle is based on the assumption that the existing distribution of resources in the economy is appropriate, which may not hold in real-life situations.

Further, estimation of the benefits received from the public goods and services is difficult: a) some of the public goods (defence, justice, etc.) are non-excludable, and hence it is difficult to allocate them individually; b) sometimes, benefits received are not direct but indirect and hence the difficulty in measurement, for example, roads benefit businesses by bringing them workers and customers.

Besides the assumption behind the benefit principle, a taxation theory may be derived by assuming that there need not be any contractual relationship between tax liability and state activities and that the tax burden should be apportioned on the basis of the ability to pay the members of the society. Simply put, individuals with a greater ability to pay a tax should pay more tax. This assumption yields the ability to pay theory.

In other words, according to the ability to pay principle, the government fixes a revenue target, and irrespective of the benefits received by the citizens, they are asked to contribute towards the targeted revenue as per their ability to pay. Under this principle, a person’s ability to pay is determined by his income or wealth.

The taxes or revenue collected by the government for the provision of public goods such as highway tolls, train fares, park admission tickets, travellers paying tolls to cross a bridge, gasoline tax, etc., are examples of the benefits principle of taxation. The benefit principle has an inherent element of fairness since an individual will pay for what he gets, and one person does not receive benefits at the expense of another person. But this idea also clashes with the common notion of fairness as in the context of public services like public schools, police, governance and hospitals. Financing is generally not done out of direct charges for their use as implied in the benefit principle rather it is done out of tax revenues as implied in the ability to pay principle since it would not be fair to suggest that, for example, sick people should pay more for public hospitals.

Taxes according to the ability to pay principle include any taxes charging higher tax on high income or wealth, for example, individual income tax, property tax, and corporate income tax. Such taxes may either be levied proportionally or progressively. Proportional levying means the same percentage being charged on high as well as low income. Progressive levying means increasing the percentage being charged from low to high income, i.e. high-income individuals not only pay higher taxes absolutely but also a higher percentage of their income.

Proportionality and progressivity in the given context may be further understood by considering two principles of ability to pay, namely the principle of horizontal equity and the principle of vertical equity. The former treats people in equal positions as equals and asks them to contribute the same amount of tax, whereas the latter treats people in unequal positions as unequal in terms of their tax liability and hence asserts that they are taxed unequally.

As per vertical equity, people with higher incomes should pay more taxes. For example, income tax wherein higher income means higher tax rates. In contrast, horizontal equity asks people with higher necessary expenses to pay less taxes as compared to others with equal income but lower necessary expenses. For example, various benefits and subsidies are available to people who have dependents as compared to those with no dependents at a given level of income.

Efficiency Principle of Taxation:

As mentioned earlier, a government imposes taxes and raises tax revenue since it has to carry out various welfare and development programmes, finance public goods or redistribute income from rich to poor. The efficiency principle says that revenue collection from it should be sufficient so as to allow the government to carry out such programmes.

It also asserts that while doing this, the efficiency of the market system should not be disturbed significantly. The effects of taxation on the efficiency of the market system can be analysed in terms of distortion in consumer or producer decisions in order to avoid taxation, brought by the tax.

As a result of a tax imposition, if individuals are not forced to alter their behaviour, i.e. if incentives of the marketplace are not distorted, then tax incidence remains on the same individuals on whom tax has been imposed. In such cases, no losses in efficiency are created. Alternatively, if tax imposition causes individuals to change their behaviour, it will create efficiency costs.

Hence, if a tax induces changes in consumer or producer decisions, the efficiency principle is not achieved. For example, a tax on a consumption good not only decreases its demand but also causes a substitution away from that good and towards lesser preferred choices not considered in the absence of the tax. Generally, there is an efficiency cost to raising tax revenue. In other words, in order to generate a unit of revenue, the welfare of the taxed individuals is reduced by more than one unit.

Taxation and Economic Efficiency: An Example

The distortionary effect of tax can be understood with the help of the concept of excess burden or deadweight loss. Deadweight loss of taxation or excess burden of taxation is defined as the loss in welfare in addition to the loss in access to resources. In other words, it measures the loss in welfare over and above the revenue generated by the tax.

Diagrammatically, welfare can be measured by the sum of the consumer surplus and producer surplus. Further, loss in welfare due to tax imposition can be measured as a change in the sum of consumer surplus and producer minus tax revenue generated.

In the figure, the initial (before tax) equilibrium quantity is shown by Q1 at price P1. After the tax is imposed, the supply curve shifts to S2 from S1. At the new price P2 (inclusive of tax = $0.50), the equilibrium quantity falls to Q2 from Q1. This fall in equilibrium quantity in the market causes a deadweight loss equal to area ABC.

Taxation and Economic Efficiency: Deadweight Loss — *Source:* Link *(Originally taken from Gruber, J. (2010) Public Finance and Public Policy, Third Edition, Worth Publishers.)*

This area is a deadweight loss because, for quantities Q1-Q2, the demand curve is higher than the supply curve, indicating that if these units were produced, there were buyers willing to pay the price higher than at which sellers were willing to supply these units. It means social marginal benefits corresponding to these units were higher than social marginal costs.

Further, the deadweight loss arises in this case because quantities consumed changed as a result of taxation; if there were no change in quantities consumed, the loss would not have arisen.

The magnitude of deadweight loss is affected by the tax rate. The marginal deadweight loss moves in the direction of the tax rate, i.e. it rises with the tax rate and vice-versa. Therefore, low taxation causes smaller inefficiency, and high taxation causes larger inefficiencies. Tax inefficiency is also determined by elasticities, as in there is a positive relation between deadweight loss and elasticities. In other words, if elasticities rise, the loss also rises. Therefore, it is held that it is more efficient to tax goods that are relatively inelastic.

Taxation and Economic Efficiency: Another View

One view is that taxation causes inefficiencies. An alternative view is that tax imposition may cause restoration of market efficiency in some cases, such as externalities. If a producer of a negative externality does not consider the external costs of his production activities, i.e. the negative externality, say, pollution, then he will tend to overproduce the product, which is an inefficient market outcome. If a tax, equivalent to the external costs, is imposed on the production of the product causing pollution, the producer will consider this extra cost and will reduce the production to the efficient level. In such cases of market failure, taxes are useful in restoring market efficiency.

Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples

Equity Principle of Taxation:

Efficiency Principle of Taxation:

Taxation and Economic Efficiency: An Example

Taxation and Economic Efficiency: Another View

Read More in: Theory of Public Finance

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Equity Principle of Taxation:

Efficiency Principle of Taxation:

Taxation and Economic Efficiency: An Example

Taxation and Economic Efficiency: Another View

Read More in: Theory of Public Finance

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Share Your ThoughtsCancel reply