8.4 Tax Evaluation Criteria

Taxes have a significant effect on the private economy and households. Key considerations include equity and efficiency of different taxes. For example, policymakers must assess whether certain taxes place a disproportionate high burden on low-income taxpayers. Additionally, they must consider the impact that taxes have on consumer and business decisions. Tax evaluation involves five criteria to assess the effectiveness and fairness of the tax system: (1) Economic efficiency, (2) Equity, (3) Adequacy, (4) Feasibility, and (5) Transparency. Feasibility can be further divided into administrative and political feasibility.

8.4.1 Economic Efficiency

Economic efficiency in taxation is related to market equilibria, which represent points where consumer and producer surplus (with social welfare as the sum of the two) is maximized. In an efficient market, goods are produced according to consumer preferences, at the lowest cost, and distributed based on willingness-to-pay. However, taxes can cause deviations from this equilibrium, potentially reducing efficiency. Instances of market failure represent exceptions to this principle, where taxes might address restore efficiency such as the case of a corrective tax on externalities.

Let us consider the example of a sales tax on bread. From a consumer perspective, the introduction of a sales tax on bread leads to substitution away from bread towards alternatives such as rice and potatoes. Those are less desirable by consumers because otherwise, they would have purchased them before in higher quantities. From a producer perspective, the taxes changes the after-tax price (price received by the producer versus price paid by the consumer) of bread. In addition to the reduction in demand, producers will be worse off as well. If producers and consumers did not react to a tax, there would not be an efficiency loss.

The questions, which need to be consider are usually the following:

• What economic decisions will this tax change? All modern taxes cause some change in economic behavior.
• How much will consumers and producers change their behavior in response to this tax?

The answer to the second question depends on whether there are good alternatives or substitutes to the good which is taxed. The more substitutes there are, the more the efficiency loss from a tax.

8.4.2 Equity

Usually, there are multiple objectives from imposing taxes. Equity in taxation focuses on fairness issues while achieving those objectives. Tax structures often incorporate equity considerations, though these can involve trade-offs (e.g., among various socioeconomic groups) or lead to unintended consequences. Two main standards of equity are the ability-to-pay principle and the benefits principle.

The ability-to-pay principle states that tax payments should be based on a person’s financial capacity, often measured by income or wealth. Within this framework, there are two notions.

Horizontal equity for which individuals with the same ability-to-pay should pay the same effective tax rate. Income as an easy measure for ability to pay but other factors that might influence “ability-to-pay” include wealth, number of children, medical expenses (from varying health conditions), and lifetime earning potential, among others.

And vertical equity for which individuals with different abilities to pay should face different effective tax rates. It addresses how the effective tax rate evolves with income. As mentioned previously, a tax system can be progressive (i.e., rate increasing with income), regressive (i.e., rate decreasing with income), or proportional (i.e., rate constant with income).

An equitable tax system is one in which each taxpayer contributes in line with the amount of benefits they receive from the service provided. The benefits principle posits that the cost of a government-provided good or service should be paid by the taxpayers who benefit from it. Payments are proportional to the benefits received. For example, a family with two children should pay a higher property tax (which is in part used for education) than a family with one child. Those could also be (more or less) proportional to the damage caused. Consider fuel taxes for example that are dedicated to road maintenance. The higher the weight on an axle, the more damage is caused to the road. Thus, fuel taxes based on the amount of fuel consumed, affects people with lower fuel efficiency more. That lower fuel efficiency is usually caused by heavier vehicles that results in more road damage. Arguments in favor of this principle suggest it aligns with intuitive fairness and encourages conservation of public services. However, it faces challenges in application, as few taxes strictly adhere to this principle, especially for public goods. Moreover, individuals less able to pay may still deserve access to public services. In addition, general taxes such as on income cannot be linked to specific services. Taxes based on the benefits principle do not redistribute income and would probably encourage governments to collect revenue in the form of user fees for many basic services. Benefit principle has been used as a justification for local user fees for services such as water, sewer, garbage, etc.

8.4.3 Adequacy

Adequacy in a tax system refers to its ability to generate sufficient revenue at reasonable rates. Broad-based taxes, like those on income or sales, are preferable as they can raise substantial revenue with lower rates. Revenue fluctuations, such as those tied to gasoline prices, affect the adequacy of tax systems. Reasonable tax rates are crucial for two reasons:

1. It’s unfair and unpopular to tax one sector disproportionately, as seen in the hypothetical case of New York raising most of its revenue from a bread tax, which would burden consumers and producers.
2. Increasing tax rates too much can reduce total revenue as people find ways to avoid the tax.

Governments prefer stable revenue sources, meaning minimal fluctuations year over year. For example, a 20% annual swing in property tax revenue would complicate budgeting and might force borrowing or service cuts. However, there’s a trade-off between stability and elasticity. An elastic tax, which responds to changes in its base, can result in unstable revenue when the base shrinks. Ideally, taxes should grow with a stable tax base.

8.4.4 Feasibility

Administrative feasibility relates to the ease of tax collection. This includes administrative costs, or the effort required by the government to collect taxes, and compliance costs, which represent the effort taxpayers must exert to meet their tax obligations. Political feasibility focuses on the public’s tolerance of taxes. Factors like tax intolerance (the rejection of new taxes), sticker shock (negative reactions to significant tax increases), and reasonableness (the perceived fairness of taxes relative to the value received) play crucial roles. Additionally, visibility affects tax popularity; lower visibility taxes are less likely to face opposition. Exportation, or the perception that outsiders contribute to the tax burden, can increase the acceptance of taxes within a jurisdiction.