The guidelines and principles established by a government for the imposition and collection of taxes are referred to as tax policy. It includes both microeconomic and macroeconomic components, with the former focused on concerns of justice and efficiency in tax collecting and the latter on the total amount of taxes to be collected and the influence on economic activity. A country’s tax framework is regarded as an important tool for influencing the country’s economy.

Tax policies affect certain groups within an economy, such as households, businesses, and banks. These policies are frequently meant to stimulate economic growth; however, economists disagree on the most effective means to achieve this.

Taxation is a political and economic issue, with political leaders frequently employing tax policy to further their objectives through changes in tax rates, definitions of taxable income, and the formation of new taxes. Specific groups, such as small company owners, farmers, and retirees, can frequently apply political pressure to lessen their tax burden. The tax law is frequently complex, with regulations that assist particular taxpayer groups while shifting more of the burden to others.

There are some main reasons why the government needs to collect taxes:

1. Market failure – mainly to discourage purchases of that product (any tax creates a disincentive, so consumers will reduce their purchases and seek alternatives).
   • Taxes can create incentives promoting desirable behavior and disincentives for unwanted behavior. Taxes can change consumers’ behavior and thus influence the market outcome. For example, in presence of externalities, an —omnipotent and ethical policymaker ≠would want to change the market outcome to reach the social optimum (otherwise there would be a deadweight loss of externality). In such a case, policymakers would implement excise taxes, carbon tax etc.
2. To generate revenue.
   • Taxation is the most important source of government revenue. Governments can use tax revenue to provide public services such as social security, health care, national defense, and education.
3. Changing the distribution of income and wealth.
   • Taxation provides a means to redistribute economic resources toward those with low income or special needs (tax revenue can be used for transfer payments such as welfare benefits).

Characteristics of a Tax

• A tax is a payment made by taxpayers, which are used by the government for the benefit of all citizens.
• A tax is not levied in return for any services rendered by the government to the taxpayers. In other words, the essence of tax is the absence of a quid pro quo.
• It is a compulsory contribution imposed by the government on the people residing in the country. Since it is a compulsory payment, a person who refuses to pay a tax is liable to punishment.
• But a tax is to be paid only by those who come under its jurisdiction.
• Similarly, persons who buy a commodity that carries a tax on it, pay the tax while others do not pay.

Objectives

• To raise revenue: The principal objective of taxation is to raise revenue for the government, which is needed for the provision of essential services and execution of other activities of the government.
• To regulate the production of certain commodities: In order to regulate the production of some certain harmful product, government imposes heavy tax on the production of such commodity.
• To control the consumption of certain commodities: Government imposes tax on some commodities which are considered to be harmful or too luxurious, such tax is meant to increase the price of the commodities, hence a reduction in the demand and subsequent consumption.
• To control monopoly powers: Certain taxes are levied in order to curb monopoly powers. Such taxes include excess profit tax.
• To redistribute income: Taxation can be applied as a means of redistributing income. A progressive tax system takes away more money from the rich and the proceeds are used in providing goods and services whose marginal utilities are higher for the poor than the rich.
• To protect infant and domestic industries: High import duties can be used to discourage the importation and consumption of foreign goods which usually out-compete the locally produced ones.
• To prevent dumping: High import duties can be used to prevent the dumping of relatively cheap products in developing economies by the more technologically advanced countries.
• To maintain balance of payment: The balance of payment deficit can be corrected by imposing taxes that discourages imports while taxes/tariffs that encourage exports are at the same time introduced.
• To curb inflation: Certain forms of tax can be used to reduce the level of inflation. A high rate of taxation without a corresponding increase in government expenditure will reduce the disposable income of consumers. This will help to reduce prices.
• To regulate business activities: The form and direction on business activities can be regulated through taxation. A tax may discourage or encourage a given line of business. A high rate of taxation will discourage a business activity while a subsidy (negative tax) encourages the same.

Operating Costs of Tax Policy

Modern taxation systems have the potential to inflict a significant burden on taxpayers, particularly small business taxpayers. This burden is often composed of three components. First and foremost, there are the taxes themselves. Second, there are efficiency costs (also known as deadweight losses or excess burden), third, there are tax compliance costs, and finally, there are administration costs (also known as running costs) of the tax system. Administrative costs are expenses incurred by (mostly) public sector agencies to run the tax-benefit system. At first look, the relationship between administrative and compliance costs of taxation is not always evident.

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There may be an inverse relationship between them at times, a phenomenon known as “the administrative-costs compliance-costs trade-off.” An installation of a self-assessment system in taxation could be an example of this inverse relationship. However, this trade-off principle is not always true, as it is possible to reduce both types of costs through tax system simplification, or an increase in compliance costs may arise as a result of administrative inefficiencies. These charges are referred to collectively as taxation running costs.

When implementing some new parts of tax policy or reorganizing it, policymakers always have to consider the weight of administrative costs and compliance costs of taxation. There are two main types of administrative costs:

1. Direct administrative costs
2. Indirect administrative costs

Direct administrative costs

Direct administrative costs are on the government side (the burden is borne by the government). “It is not immediately obvious, exactly, which activities should be attributed to the operation of the … system” Administrative costs are mainly connected to running the tax collection office – it includes salaries of staff, costs of legislative enactment relating to the tax system, judicial costs of administration of the tax dispute system, and many more.

Indirect administrative costs

Indirect administrative costs are on the side of taxpayers (the burden is borne by the government). Tax compliance costs are those costs “incurred by taxpayers, or third parties such as businesses, in meeting the requirements laid upon them in complying with a given structure and level of tax” Indirect administrative costs are mainly connected to the costs of complying with tax requirements – it includes the costs of labour/time consumed in completion of tax activities, filling out forms, record keeping, the fees paid to professional tax advisers, transfer pricing and many more.

Compliance costs

Tax compliance costs are the costs “incurred by taxpayers, or third parties such as businesses, in meeting the requirements laid upon them in complying with a given structure and level of tax”. There is no consensus about what should and should not be included under the definition of compliance costs. However, there is a possibility to define some indisputable examples of costs, that are directly connected to the compliance of individual taxpayers.

These examples include the costs of labor and time required for the completion of tax activities, such as acquiring the necessary knowledge to operate within the tax system properly or compiling and creating all documents needed. More examples include the cost of purchasing professional assistance for the completion of tax activities, or other expenses connected to tax activities, such as purchasing software and hardware.

Other types of compliance costs, such as the negative psychological effects on taxpayers as a result of the attempts to comply with the current tax policy, or many types of social costs, are very intangible, and it is, therefore, hard to quantify them, even though the effect of their existence is visible.

Problems Faced by Tax Policymakers in Developing Countries

Tax policymakers in developing nations have a number of obstacles that make it difficult for them to implement effective and equitable tax systems, combat inequality and corruption, and advance their development levels. As a result, developing countries frequently employ tax policies that are ineffective in terms of producing tax revenue, denying the country the funding it requires for development.

Unclear incomes

As many people in developing countries are often paid wages based on the time they spend at work (volatile value), and many are paid in cash which lowers the government’s ability to track such money-flows, it is difficult to keep record of any reliable data on income and wealth distribution in the country. This leads to a situation in which the policymakers are unable to create statistic or models that would allow them to propose changes to the current tax system (mainly income taxes in this case) in the country, that would improve the situation (mainly the efficiency vs. equity trade-off).

Unclear spendings

Similarly to the problem regarding unclear incomes, a big part of the spending in developing countries is done in such a way that does not lead to extensive spending reports being supplied to the government. This lack of information is supported by the fact that just like in the case of incomes, most spending is done in cash which is, again, more difficult to keep record of. In this situation, policymakers are deprived of the ability to analyze spending statistics in their country and thus they are not able to produce changes to the tax system (mainly the sales taxes) in their country.

Limitations on taxing imports

“With regard to taxes on imports, lowering these taxes will lead to more competition from foreign enterprises. While reducing protection of domestic industries from this foreign competition is an inevitable consequence, or even the objective, of a trade liberalization program, reduced budgetary revenue would be an unwelcome by-product of the program.”

Limitations of Used Taxes

Despite the difficulties in tracking many economic activity in underdeveloped countries, various levies are naturally in place in these countries. These create revenue, but they have restrictions that make them less effective than they could be.

Personal income tax

The personal income tax in developing countries commonly have some rate of progressivity, meaning grouping individuals into various groups based on their income and then imposing different rates of the personal income tax on each group. The limitations which often make this kind of tax ineffective in developing countries are several various exemptions in the parts of individual’s income that are taxable as well as setting off the borders between different tax brackets.

These make it often more favourable for an individual to establish a business and therefore pay (lower) corporate income tax rather than personal income tax. But even without this, reaching the highest tax bracket (with the highest marginal tax rate) as an individual often requires incomes so high that only a small number of people in the country reach it.

Corporate income tax

Similarly to the case of the personal income tax, there are various rates of the corporate income tax based mainly on the sector that the company generates revenue in. This allows the corporations to take actions that allow them to pay lower taxes and effectively practice tax avoidance.

Value added tax

As much as the VAT is an effective tool to generate revenue for the government, there are some setbacks to the implementation of the VAT in developing countries. One is that there are certain goods and services which are not included in the VAT list and therefore “reduce the benefits from introducing the VAT in the first place.”

Another one is introducing various VAT rates for different goods and services. This usually leads to a higher popularity of the tax policy and can even increase the revenue of the tax but the administrative cost of such a measure can outweigh said benefits, especially in the case of developing countries.