E LAW - MURDOCH UNIVERSITY ELECTRONIC JOURNAL OF LAW VOLUME 1 NUMBER 4 (DECEMBER 1994) Copyright E Law and/or authors Review of Western Australian State Taxes 1994 Chapter 10 EQUITY Introduction Horizontal Equity Vertical Equity (1) Club Australia (2) The Liberal Theory (3) The Socialist View Summary Taxation Incidence Tax Mix, Government Expenditure and Tax Relief Conclusion Bibliography INTRODUCTION We have been conditioned to accepting that equity means fairness and has two dimensions. These two dimensions are common to almost all the literature on taxation.[1] Horizontal Equity: People in similar economic circumstances should be treated similarly. Vertical Equity: People in different situations should be treated differently, with a greater share of the tax burden being borne by those with greater capacity to pay. Horizontal equity is achieved by equality whereas vertical equity is almost invariably achieved by inequality and in the latter case the requisite degree of inequality depends upon the political viewpoint of the observer. HORIZONTAL EQUITY Any consideration of equity involves a comparison. The basis for comparison may not always be clear. For example land tax levied in proportion to the value of the land held could be said to be horizontally equitable since land of the same value would attract equal tax. On a wider view it is horizontally inequitable because a person who holds 10% of their wealth in land would pay more tax than another who only holds 5% in land. The policy justification for taxes is commonly derived from distortions induced by horizontal inequality. For instance, there will also be differences in the way in which otherwise equal land holdings are held. The existence of land tax will mean that people will be averse to holding wealth in the form of unproductive land and the tax will therefore create pressure for land to gravitate to people who will use it productively to increase their personal wealth. VERTICAL EQUITY Vertical equity is essentially a matter of political judgement. According to the political inclinations of the observer there are three available approaches which are fundamentally different. The arguments for each of them are set out below. (1) Club Australia A country is like a golf club. A member must pay the subscriptions. It makes no difference whether the member is a doctor, lawyer, university lecturer or unemployed. It is irrelevant whether the member uses the golf course once a month or six times a week. Similarly the handicap of the golfer is irrelevant. The determining factor is the rights obtained and not the rights exercised. Australia is similar. The services provided by the government are available to everyone and whether everyone uses them equally is irrelevant. The services have to be paid for and should be paid for equally by everyone irrespective of income. If the Australian government needs x amount of dollars to function then x should be divided by the population of Australia to arrive at an equitable distribution of tax liability. An example of a Club Australia philosophy is poll tax. The Club Australia footprint. Every person who is liable to pay tax pays the same amount of tax regardless of the persons income e.g. poll tax. (2) The Liberal Theory Club Australia theory sounds reasonable but a closer examination reveals that it is neither practical nor logical. It is not practical because the services that are provided by government are so expensive that the tax liability for those on low income would exceed their income. The comparison with a golf club is inappropriate because a prospective member can choose whether to join or not. The same freedom does not apply to Australian citizenship and the moral considerations are therefore different. The function of government is to provide the environment for liberal pursuits, including the creation of wealth. Therefore, the cost of maintaining a nation should not be apportioned according to a theoretical right to participate in national life; rather it should be apportioned according to the benefits derived from it. The benefit that is derived from simply living in a country can be assessed by the amount that an individual earns. On the assumption that there is a direct correlation between income and spending, a practical way of doing this is by imposition of a consumption tax. A person who earns nothing receives nothing and should pay nothing. Spending increases with income and the tax burden increases proportionately. If income doubles, benefit derived from the nation doubles and the contribution to the maintenance of the nation should also double. Alternatively, it is reasonable to take the view that everyone needs a certain income simply to exist, ie for food and housing. On this premise it is reasonable to start taxation at some pre-determined level below which no tax is paid (a tax threshold). The tax rate would have to be higher to compensate for tax revenue forgone but nevertheless it would be equitable because an equitable tax scheme cannot deny any of its citizens the bare necessities of life. This can be achieved with a flat rate income tax commencing at a determined threshold level. Liberal Theory equitable footprints dictate that tax is paid in direct proportion to income (left e.g. a broad based consumption tax) or, in direct proportion to income over a certain threshold level (right e.g. a flat rate income tax commencing after a certain level of income is obtained). Liberal Theory equitable footprints dictate that tax is paid in direct proportion to income (left e (3) The Socialist View Liberal theory is an improvement on the Club Australia approach to the extent that those on higher incomes pay higher taxes. The tax threshold concept is essential to equity but even the second version of liberal theory still suffers from two fundamental flaws. Firstly, the benefit that a person derives from the nation is not in direct proportion to the amount by which his or her income exceeds subsistence level. Above subsistence level any funds are used to create comfort. As wealth increases comfort becomes luxury and eventually raw power by virtue of the economic system. The greater the excess funds the greater the power that can be exercised. In order to achieve social equity income which facilitates lower hierarchal needs should be taxed at a lower rate than income which tends to satisfy the higher needs. Secondly, it is a legitimate function of government to redistribute wealth from the affluent to the poor in the interests of social justice. A corollary of democratic political theory is that each individual is not only entitled to a share of political power (the right to vote) but also to a minimum share to economic power ie a right to a minimum share of the nation's wealth. The effect of the socialist view is that vertical equity demands not just a flat tax scale but a progressive tax scale to achieve fairness. This can be achieved by taxing income above a threshold level at incremental rates determined by gross income. The equitable footprint of socialists. The greater the income the greater the amount of disposable income (that left after paying for necessities). Tax rate rises with income. Summary The above analysis is argued as a progression from the political right to the left. All the arguments are based on the proposition that taxation should be structured according to the benefits principle.[2] This assumption is tenuous: there are cogent social and political arguments for divorcing the two concepts.Furthermore, assessment of the equity of a tax may also have to take into account the incidence of a tax and the expenditure scheme of the tax collected. TAXATION INCIDENCE The burden of taxation may not remain at the point where it is imposed. The classical example is the imposition of a tax on the production of a good. If demand for widgets is inelastic consumers will continue to buy them and bear the tax. As elasticity increases demand will decrease if the tax is passed on so the supplier will have to bear a higher tax burden. Elasticity may be the result of consumers doing without the type of good or service taxed but, more commonly, it is largely dependant upon the availability of substitute goods or services which are not subject to the tax. If such goods or services exist, a horizontal inequity is produced which results in market distortion measured by elasticity. To reduce the effects of distortion (and reduce elasticity) the tax base must be increased to include substitute goods. Broadening the tax base does not necessarily mean covering all aspects of an economy; it is only necessary to cover the economic sector that is being taxed. For example, if a tax is imposed on deposits in bank accounts a horizontal inequity is produced which distorts behaviour by inducing greater use of building societies and credit unions. Horizontal equity can be restored by taxing the universe of financial institutions. If horizontal equity exists within the sector the only options left to consumers are to pay the tax or exit the sector and return to cash transactions. Because of the convenience of cheques and electronic transfers the effect of the second option will be minimal. TAX MIX, GOVERNMENT EXPENDITURE AND TAX RELIEF Analysis of any existing tax can only be of academic (or political) interest until that analysis is integrated into the overall tax mix and the effects of government expenditure and tax relief (or breaks) are considered. There may be instances where vertical inequity occurs with respect to a particular tax but the inefficiency and revenue loss involved with redressing the inequity is prohibitive. Since the underlying function of taxation is to provide money for government, removing the tax is not a viable option. There are three ways of compensating for such inequities: i) adjusting a more flexible tax to induce an inequity approximately equal and opposite to the first tax; ii) direct government expenditure to people adversely affected by the tax; iii) creating tax relief (breaks) to people adversely affected. For example, consider an economic entity with no welfare payments and a government which obtains its revenue entirely through progressive rate income tax with a tax free threshold. The equitable footprint of this strategy would be similar to a country which relies largely on a consumption tax for government revenue but supplements low income earners with transfer payments and has a greater tax threshold and a greater difference between the lowest income tax rate and the highest. This is not to say that any consideration of a proposed tax in isolation is without merit. Analysis of the equity of the new tax or an increase in an existing tax will provide useful information for predicting the effect on the overall tax mix. CONCLUSION Horizontal equity analysis is useful for predicting economic distortions and the vertical equitable footprint can be compared with the existing tax mix footprint to assess the impact of the tax with respect to notions of social justice. However, both concepts may have to take government expenditure into account in order to complete the picture. BIBLIOGRAPHY BAUMOL, W.J., & BLINDER, A.S., Economics: Principles and Policy, 5th Ed, Harcourt, Jovanovich and Brace, Florida, 1991. COMMONWEALTH OF AUSTRALIA, Reform of the Australian Tax System: Draft White Paper (Canberra: Australian Government Printing Service, 1985). [1] For example see: "Reform of the Australian Tax System" Draft White Paper, June, 1985, paragraph 1.2. [2] Baumol, W.J., & Blinder, A.S., Economics: Principles and Policy, 5th Ed, Harcourt, Jovanovich and Brace, Florida, 1991, 704.