Questions and Answers   

What is the best way for a government to collect tax revenue?

Evaluating a tax system or changes to a tax system is a challenging task. In part this is because of the complexities of tax systems. Typically, a system of taxes and other revenues is made up of many different revenues sources: sales taxes, income taxes, property taxes, and government charges and fees. Usually, a change to any one of these pieces has effects for the characteristics of the system as a whole. In this way, analyzing the impacts of any tax change requires understanding how this change will affect the entire tax and revenue structure already in place.

However, even with an understanding of the relationships between the various pieces of the tax system, we still must have a framework for evaluating the performance of the tax system. Public finance economists generally agree on a few major criteria with which to evaluate changes in a tax system. These major criteria are: equity, efficiency, adequacy, and stability/predictability.

An equitable tax or tax system is one that provides a fair distribution of the tax burden. This distribution is both across households and businesses, as well as across different types of households and businesses. That is, is the tax burden distributed fairly between households and businesses? Is the burden distributed fairly between households of different income levels? Between small and large businesses? Between homeowners and renters? A fair distribution does not need to mean an equal distribution, and of course the ‘fairness’ of a tax distribution is highly subjective. Yet, it is possible to examine a tax change to evaluate how the change will alter the distribution of the tax burden, though it is up to the public to decide whether these changes move the system towards a more or less equitable one.

Efficiency refers to the effect of a tax system or a tax change on the decisions made by households and businesses. Generally, an efficient tax system is one that is neutral, in the sense that it does not alter the individual decision making process. In practice, however, tax systems are often viewed as ways to potentially encourage certain activities while discouraging others. As such, an efficient tax system is also commonly viewed as one that encourages businesses to locate and households to live, work and shop in an area while minimizing the incentives to undertake these activities elsewhere.

An adequate tax system is one that generates a sufficient amount of revenue for government to provide services to the public. Clearly, the issue of how much revenue is needed is largely a political one. Yet, a tax change can be evaluated to determine how the new level of revenue may compare to the existing one.

There is no single tax or tax system that is perfect. Indeed, one reason for seemingly complex tax systems in practice is that the various benefits and costs of each type of tax according to each criterion partially balance each other.

 

Return to Questions