Let us make an in-depth study of the objectives and canons of taxation by the Government of India.
Objectives of Taxation:
The major objective of taxation is to raise revenue. But certain other objectives are also important in the design of a tax system.
In many ways the market system works well. Adam Smith’s invisible hand provides the consuming public with a steady flow of goods and services. As a starting point, therefore, a tax system should be designed to be neutral. That is, it should disturb market forces as little as possible.
There is, however, an important modification that must be made to the neutrality principle. In some cases it may be desirable to disturb the private market. The government might tax polluting activities so that firms will do less polluting.
The market is disturbed but in a desirable way. Another example is the tax on cigarettes, which, in addition to its prime object of raising revenue for the government, also discourages cigarette consumption. So there is the need to meet social objectives by imposing taxes.
Taxes represent both sacrifice and compulsion. Therefore, it is important that taxes be both fair and give the appearance of being fair.
There are, however, two different principles for judging fairness, which are explained below:
(a) The Benefit Principle:
This principle recognizes that the purpose of taxation is to pay for government services. Therefore, those who gain the most from government services should pay the most. If the government follows the benefit principle of taxation it must estimate how much various individuals and groups benefit and set taxes accordingly.
The Benefit Principle simply holds that different individuals should be taxed in proportion to the benefit they receive from government programmes. Just as people pay money in proportion to their consumption of private bread, a person’s taxes’ should be related to his (or her) use of collective goods like public roads or parks. Those who receive numerous benefits should pay more than those who receive few.
However, this principle is difficult to apply in practice and it is normally observed that those who receive the maximum benefit from public expenditure pay very little — if any — tax. So another principle of taxation has been developed.
(b) The Ability-to-pay Principle:
It is the principle that states that individuals should pay taxes according to their ability to pay. If the government sets taxes according to this benefit principle it does not redistribute income. But if it sets taxes according to ability to pay, the rich should pay more than the poor. The ability-to-pay principle simply states that the amount of taxes people pay should relate to their income or wealth.
The higher the wealth or income, the higher the taxes. Usually tax systems organized along the ability-to-pay principle are also redistributive, meaning that they raise funds from higher-income people to increase the incomes’ and consumption of poorer groups. An individual who earns Rs. 50,000 per month is able to pay more taxes than an individual who earns Rs. 2,500 per month.
If the government levies a progressive tax on income and wealth and, at the same time, provides assistance to poor people, it would substantially redistribute income from the rich to the poor.
However, this principle may be simple to state but it is not easy to implement. The government levies many taxes and most of these are proportional or even regressive. Overall high income groups pay only a slightly higher percentage of their incomes in taxes than do low income groups. It is on the expenditure side the government has its greatest effect in redistributing income.
The basic object of taxation should be to ensure equality or fairness. This is of two types — horizontal and vertical. The former refers to the rule of taxation whereby equal income is taxed equally — no matter how it is earned.
According to the latter the rule of taxation should be such as unequal income is treated unequally — perhaps according to the ability to pay or to the benefits received. If the government is to achieve equity, a tax system should have certain desirable characteristics — known as the canons of simplicity, convenience, productivity and so on. Most tax systems are based on a realistic compromise among different principles and canons.
Canons of Taxation:
Tax is levied compulsorily in order to defray the expenses of the government. In the opinion of economists, collection of taxes should be based upon some principles or canons. These are also known as the qualities of a good tax system.
Adam Smith laid down the following canons of taxation:
1. Canon of Ability:
The State is necessary for all—rich and poor. Without the State, nobody’s life or property is safe. So everyone is required to pay taxes to meet the expenses of the State. But a person who earns Rs. 50,000 a year has not the same taxable capacity as the person who earns Rs. 10,000 a year. The canon of ability states that a person should be made to pay taxes according to his ability to pay. If everyone pays according to his ability, there is equality of sacrifice. So this rule of Adam Smith is also known as the canon of equity.
2. Canon of Certainty:
The principle of certainty requires that the tax which every individual has to pay should be certain and not arbitrary. “The time of payment, the amount to be paid ought all to be clear and plain to the contributor and to every other person.”
3. Canon of Convenience:
The time and manner of tax payments should be made as convenient to tax-payers as possible. The Pay- As-You-Earn (PAYE) method of collecting personal taxation under which an employer deducts tax on behalf of employees and pays it to the Finance Department is a good example of this quality. For this reason, the salaried persons are taxed at the source, that is at the source of income.
Some taxes are collected by installments so as to make it convenient for the tax-payer to make the payment in small amounts. On the other hand, self-employed people and companies have to put aside money reserves to pay the tax when they are assessed.
4. Canon of Economy:
According to Smith again — “every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the State.” A tax whose collection involves high expenditure should be avoided. Taxes should be levied in such a way as to minimize the cost of collection in terms of resources collected. In modern times two other canons of taxation are also recognized as beneficial.
5. Canon of Elasticity:
A tax should be sufficiently elastic in yield. The amount of tax ought to be so contrived that it can be varied according to the needs of the government. For instance, the rate of income tax is variable. In modern times, all taxes and their rates can be varied.
The rate of income tax is liable to be changed according to the changes in the level of income of the people. The land revenue is, however, fixed for a period. It is not liable to be changed as is possible in the case of income tax. In case of crop failure, the government can, of course, grant remission.
6. Canon of Productivity:
All taxes should be productive. It is better not to impose a tax whose yield is negligible. The canon of productivity implies that taxes should be imposed in such a manner as not to hamper production or to decrease the volume of resources collected. In other words, the levy of a tax should not only increase the income of the State, it must not also destroy the incentives of the people to undertake productive enterprises.
These canons of taxation are regarded as characteristics of a good tax system. However, most of these characteristics are not present in India. Firstly, the Indian tax system is regressive in nature. The major portion of the Government of India’s revenue is derived from indirect taxes. Such taxes are usually imposed on consumption spending. Poor people spend the major portion of their income on consumption goods and, thus, they pay the major portion of taxes.
The Indian tax system is not equitable either. It creates inequality. Since the poor people pay the major portion of indirect taxes there is more and more inequality in the distribution of income. The Indian tax system is not productive either. Although the rate of income tax in India is very high the collection from such tax is very low.
Moreover, the Indian tax system is not simple. It is very complicated. There is not only tax on finished goods that we buy but also on raw materials and intermediate goods. So indirect taxes cause inflation from the supply side by creating cost-push pressures.