This article was written by Shipra Agrawal, pursuing the Diploma in US Corporate Compliance Course from Skill Arbitrage, and edited by Koushik Chittella.

This article has been published by Shashwat Kaushik.

Introduction

Taxation is an essential component of any government system. It allows the government to generate the revenue required to maintain public services, infrastructure, and various other essential functions. Taxes play a critical role in funding social programs, healthcare, education, and defence. But how does the tax system work, and what are the guiding principles that make it effective? Understanding the basics of taxation helps us to manage our money and contribute to the community. Nowadays, governments have developed more sophisticated systems and processes for defining tax, who is taxed, how much is taxed, and which personal conditions of the taxpayers should be taken into account. Let’s explore the simple principles of taxation and how these impact our daily lives. In this article, we will explore the history of taxation, the reasons behind it, and its various forms before discussing the principles of taxation.

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Brief history of taxation

Taxation has been a part of society for thousands of years, starting as far back as ancient Egypt and Mesopotamia, where taxes were collected in the form of crops, shares of agricultural production, and livestock for the ruling government. In the Roman Empire, taxes were more structured, and citizens were required to pay based on their income and property. However, taxes were collected in the form of crops and livestock also, and even in mediaeval Europe, where a similar taxation system became one source of financing.

Taxes used to be messy and unfair. Over a time, with the rise of democracies and structured economies, the tax system became more standardised, and laws were created to make taxes more fair and transparent. Now, modern tax systems help countries manage their money and resources in a way that’s fair for everyone. 

Tax: meaning

Tax is the contribution from the public to a governing body to support the government for all public needs. In simple terms, when we pay taxes, we are helping to fund things like roads, schools, hospitals, defence, and other community services that everyone benefits from. Taxes can take various forms, such as income tax, property tax, corporate tax, Goods and Services tax, Capital gain tax, etc. 

Need for Taxation

The economic resources available to society are limited, and so an increase in government expenditure normally means a reduction in private spending. Taxation is one method of transferring resources from the private to the public sector. Governments often use other methods of raising resources. Taxation is usually the most important source of government revenue. Most countries have a tax system that differs from that of other countries. Taxation is necessary for several reasons:

  • Revenue Generation: Governments need money to provide essential services like healthcare, education, defence, infrastructure, and social welfare. Without taxes, these services would not be possible.
  • Redistribution of Wealth: Reducing income inequality through progressive taxation. In simple terms, taxes help redistribute wealth in society by taxing higher earners at higher rates and using those funds for social welfare programs that support low-income individuals.
  • Economic Stability: When the economy is growing too quickly, governments can raise taxes to reduce excessive demand and control inflation. Conversely, during a recession, cutting taxes can encourage consumer spending and investment, helping to stimulate economic growth.
  • Encouraging or discouraging behaviours: Governments can impose higher taxes on harmful products like cigarettes or alcohol to discourage their use or provide tax breaks for environmentally friendly practices.

Principles of Taxation

We already discussed what is taxation; now what are the principles of taxation? Principles are nothing but a basic general law, rule, or idea. Adam Smith (1723-1790), known as the “Father of Modern Economics,” laid the foundation for modern taxation principles in his book “The Wealth of Nations” (1776). He introduced the “Canons of Taxation,” which include: a. equality, b. certainty, c. convenience, d. economy.

Adam Smith created important rules for taxation a long time ago. He believed taxes should be fair, clear, easy, and cost-effective, but as time passed, people realised that taxes are more complicated than that. So, new rules were added to help deal with modern economic problems.

So, here are all the principles categorised in 2 ways:

   I.          Classic Principles

II.          Modern Principles

  1. Classic Principles

Classic principles of Taxation include:

  • Equality: This principle is based on the idea that the tax burden should be distributed in a fair manner. It means tax should be levied on the taxpayers according to their ability to pay. Individuals with a higher income should contribute more tax, and individuals with a lower income should pay less tax.
  • Certainty/Clarity: This principle states that the tax system should be clear, transparent, and certain with no surprises to taxpayers. Taxpayers should know their tax obligation, when to pay, and how to pay.
  • Convenience: The method of payment of taxes should be convenient to the taxpayers. Tax collection methods should be easy, such as online or payroll deductions. There should be minimal compliance requirements and less paper work.
  • Economy: The cost of collecting taxes should be cost-effective and efficient. A well-designed tax system minimises its administrative cost and taxpayer burden. A simple tax return process with easy-to-understand regulations reduces administrative costs and compliance expenses.
  1. Modern Principles
  • Productivity: The productivity principle says that a good tax system should help people and businesses work efficiently and effectively. It means that taxes should be designed in a way that encourages people to work hard, innovate, and invest in their businesses. This way, the economy can grow, and people can have better lives. The tax system should not be too complicated or too expensive so that people can focus on creating value and wealth rather than wasting time and money on taxes.
  • Elasticity/flexibility: This principle says that the tax system should be able to adjust to different situations and needs. It means that taxes should be designed to be flexible so that they can be easily changed or updated as circumstances change.
  • Simplicity: The tax system should be simple to understand and easy to follow for the taxpayers. There should be simple calculations and less paper work. A complicated tax system results in increased costs, errors, and opportunities for tax evasion. It means the whole tax system should be user-friendly and not complicated.
  • Diversity: This principle says that the tax system should be flexible in the context of the charging of tax. It means there should be different ways of charging tax as per different types of taxpayers. Like income level, family status, or business type. For instance, while taxing old people, there should be some deductions, a different tax rate, or relaxations.
  • Expediency: While creating rules, the government should consider the social and economic needs of various communities, like low-income families and small businesses. They should also think about their political goals, like helping the economy grow and reducing inequality. They should also think about what’s different about cities and rural areas.
  • Co-ordination: This principle says that there should be a balanced tax system and teamwork between the central and state governments. When the central government and state governments don’t work together on tax policies, it creates confusion and complexity. Tax laws and rules may overlap or conflict with each other, leading to double taxation (paying taxes twice on the same thing).

Impact of Taxation in our daily life

Taxation impacts our daily lives. The income tax system, for instance, imposes a direct cost on earners, thereby affecting their disposable income and spending power. This not only impacts individual financial planning but also dictates consumption patterns and saving behavior. Additionally, indirect taxes like the Goods and Services Tax (GST) influence the prices of goods and services, affecting the cost of living and the overall inflation rate. These taxes ensure the continuous flow of revenue necessary for the government to provide infrastructure, healthcare, education, and social welfare programs, ultimately contributing to the holistic development of society. Taxes reduce our disposable income, affecting spending and saving habits, while tax incentives shape investment choices, retirement planning, and homeownership decisions. Tax policies also impact job creation, entrepreneurship, and income inequality, ultimately affecting our standard of living.

Beyond the economic realm, taxation also affects societal dynamics and quality of life. The structure and efficiency of tax collection can impact perceptions of fairness and trust in governmental institutions. A transparent and equitable tax system can foster a sense of civic responsibility and social cohesion among citizens. On the flip side, complexities and inefficiencies in the tax system can lead to evasion, corruption, and a lack of trust in public administration.

Conclusion

In conclusion, understanding taxation principles is important because they show how taxes impact our lives and the economy. These principles, like fairness, simplicity, and flexibility, help create tax systems that are fair and easy to follow. They ensure that everyone pays their fair share, that the government can fund public services, and that taxes don’t cause too much stress or confusion. When tax systems are well-designed using these principles, they support a healthy economy, reduce inequality, and improve the overall well-being of society. Understanding taxation principles is essential for effective financial management, as taxes significantly impact individual and business finances. By knowing how taxes work, we can make smart decisions, save money, and achieve our financial goals. Staying up-to-date on tax laws helps us adapt to changes and secure a brighter financial future. 

References 

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