Theories Of Optimal Taxation


This study discusses seven theories that provide the theoretical background of this study. These theories are: the theory of optimal taxation, the ability to pay theory of taxation, the expediency theory of taxation, the benefit theory of taxation, the cost of service theory of taxation, the partnership theory of taxation and Khaldun’s theory of taxation. The second part discusses the challenges that face collection of turnover tax ending up with a conceptual framework explaining the relationship between the challenges and the revenues. The final part of the literature review discusses other studies conducted that are relevant to this study.

The Theory of Optimal Taxation

The standard theory of optimal taxation posits that a tax system should be chosen to maximize a social welfare function subject to a given set of constraints. Much of the literature on optimal taxation treats the social planner as a utilitarian, that is, the social welfare function is based on the utilities of individuals in a society. In its most general sense, this literature uses a social welfare function that is a nonlinear function of individual utilities. Nonlinearity allows for a social planner who prefers, say, more equal distributions of utility. However, some studies in this literature assume that the social planner cares exclusively about average utility, implying a social welfare function that is linear in individual utilities (Mankiw, Weinzierl, and Yagan, 2012). To simplify matters for the social planner, it is repeatedly assumed that everyone in society has the same preferences over consumption and leisure, for instance. Sometimes this homogeneity assumption is taken further by assuming that completely identical individuals populate the economy. The social planner’s goal, therefore, is to choose the tax system that maximizes the representative consumer’s welfare with knowledge that the consumer will respond to whatever incentives the tax system provides. This theory suggests that TOT should be a tax, like others, that should be seen as a tax that maximizes social welfare (Mankiw et al., 2012).

The Ability to Pay Theory of Taxation

According to this theory, tax liability in its true form is a compulsory and an unconditional payment to the state. The theory posits that there is no commercial or semi-commercial relationship between the state and the citizens. A citizen is to pay taxes just because he or she can and his or her relative share in the total tax burden is to be determined by the relative paying capacity. This doctrine has been in vogue for at least as long as the benefits theory. The basic tenet of this theory is that the burden of taxation should be shared by the members of society on the principles of justice and equity and that these principles necessitate that the tax burden is apportioned according to their relative ability to pay. This theory suggests that the payers of TOT should pay unconditionally and according to paying capacity (Chigbu, Eze and Ebimobowei, 2012).

The Expediency Theory of Taxation

The expediency theory asserts that every tax proposal must pass the test of practicability. It must be the only consideration when the authorities are choosing a tax proposal. Economic and social objectives of the state should be treated as irrelevant. This proposition has a truth in it, since it is useless to have a tax which cannot be levied and collected efficiently. There are pressures from economic, social and political groups. Every group tries to protect and promote its own interests and authorities are often forced to reshape tax structure to accommodate these pressures. In addition, the administrative set up may not be efficient to collect the tax at a reasonable cost of collection. Taxation provides a powerful set of policy tools to the authorities and should be effectively used for remedying economic and social ills of the society such as income inequalities, regional disparities, unemployment, cyclical fluctuations and so on. TOT should result from a balance of the forces (Bhartia, 2009).

The Benefit Theory of Taxation

According to Benefit Theory, the state should levy taxes on individuals according to the benefit conferred on them. The more benefits a person reaps from the activities of the state, the more the tax the person should pay to the government. This principle has been criticized because, first, if the state maintains a certain connection between the benefits conferred and the benefits derived, it will be against the basic principle of the tax. A tax is basically a compulsory contribution made to the public authorities to meet the expenses of the government and the provisions of general benefit to all citizens (Dodge, 2005). Secondly, most of the expenditure incurred by the state is for the general benefit of its citizens, it is not possible to estimate the benefit enjoyed by a particular individual every year for it to be decided how much tax this individual should be charged. Further, if we apply this principle in practice, then the poor will have to pay the heaviest taxes, because they benefit more from the services of the state. If we get more from the poor by way of taxes, it will be against the principle of justice. According to this theory there should be some benefit to those who pay TOT (Dodge, 2005).

The Cost of Service Theory of Taxation

This theory is based on the opinion that if the state charges the actual cost of a service from the people, it will satisfy the idea of equity or justice in taxation. The cost of service principle can no doubt be applied to some extent in those cases where the services are rendered out of prices and are a bit easy to determine. However, most of the expenditure incurred by the state cannot be fixed for each individual because it cannot be exactly determined. For instance, it is not easy to measure the cost of service of the police, armed forces, judiciary, etc., to different individuals. This theory implies that TOT should be charged basing on the cost of the services to be tendered to the payers. This may be difficult to achieve (Mastrianna, 2009).

Empirical Literature Review

The Cost of Implementation and Taxation greatly affect the implementation of turnover tax. Depending on the type of tax, the actual cost of collecting taxes in developed countries is roughly one percent of tax revenues. In developing countries, the cost of tax collection may be substantially higher. Other costs include the compliance costs and administration cost that taxpayers and collectors incur over and above the actual payment of tax. In many cases, administration costs are reduced when compliance costs are increased. For instance, when taxpayers are required to provide more information, they incur more costs, but tax administration gets easier and less costly (Sandford, 1995).

Third world countries incur heavier compliance costs (financial and time) of complying with the tax law. The costs manifest when acquiring the knowledge and information needed to comply, setting up required accounting systems, obtaining and transmitting the required data, and payments to professional advisors. A study by Chattopay and Gupta (2002) in India suggests that compliance costs may be as much or more than ten times higher than in developed countries. Registration practices are often unnecessarily bureaucratic and may involve multiple agencies, and multiple crosschecks; complex due to the different laws, norms, documents and forms required; expensive, and time-consuming.

Delays in business registration, which often involves multiple government institutions including the tax administration, can be a significant impediment to business formation and particularly harmful to the small entrepreneur with limited start-up cash reserves. In Australia and Canada a business can be opened within 2-3 days—elsewhere, it can take over 100 days in others. For the SME operating with limited capital and professional support, such start-up delays and increased costs raise the risk of failure. Such a frustrating situation can lead to SMEs being formed without proper registration and avoid the detection by the tax collection agency and become untraceable (International Tax Dialogue, 2007).

Filing returns and paying taxes can be extremely burdensome and difficult for SMEs, particularly if the forms are complex, the requested information hard to obtain, and return filing requires time-consuming visits to a local tax office in order to comply with tax obligations. For tax administrators, SME returns represent the bulk of forms received and processed. These returns, unlike large taxpayers‟ returns, have a disproportionate number of inconsistencies, missing information, and (presumed) unintentional errors. High benefits can be realized where there is return simplification, plain language instructions, bank payment processing, reductions in filing and payment frequency, and e-filing and epayment acceptance (International Tax Dialogue, 2007).

Small businesses form the core group of hard-to-tax taxpayers. It is not uncommon in developing countries that a larger percentage of small businesses operate in the informal rather than in the formal economy. While small businesses in no way constitute the only source of underground economy activities, data about the size of the underground economy still can provide a proxy for the scope of the problem (IFC, 2007). Schneider and Torgler (2007), using various statistical procedures and data from 110 developing, transition, and OECD countries, estimate the size of the underground economy in developing, developed, and transition countries.

Analysis on a regional basis thus indicates that the level of activities of the underground economy is substantially higher in developing and transition countries compared to developed countries. In Africa, 41 % of GDP comes from the informal sector, in Central and South America 41 %, in Asia 29 %, in Economies in Transition 35%, in European OECD countries 18 %, and in North American and Pacific OECD countries 13%. As they found, while some developing countries showed a level of informal sector activities comparable to OECD countries, the informal economy in other countries exceeded 50% of GDP. SMEs with closer ownership and management linkages have greater propensity to underreport some or all of their income unlike the large scale firms.

Despite the strong foundation provided by the tax collection system and streamlined procedures, many SMEs exploit loopholes afforded by, for instance, single-owner operations and cash intensive businesses. The overall integrity of any tax system is dependent upon the public‟s perceptions of its enforcement effectiveness, that is, through predictable and prompt enforcement action against non registration and following non filing and nonpayment. The administration therefore must aggressively pursue, at a minimum, medium-to-high-risk non-filers and taxpayers who misreport. Turnover tax also suffers from tax evasion. Tax evasion refers to illegal practices that will lead to escape from taxation.

Tax evasion occurs when the amount and/or the source of income are misrepresented, or tax reducing factors such as deductions, exemptions or credits are deliberately overstated. Tax evasion occurs in the informal economy where the whole activity takes place in an informal manner. This means the business is not only evading tax payments but is also not registered as formal enterprise at all (Chiumya, 2006).

Tax fraud and evasion are also a result of a weak judiciary. Addressing revenue shortfalls needs to go hand in hand with legislative reforms strengthening the rule of law. This includes insufficient punishment and prosecution of violators which can only be tackled when detected tax criminals face stricter penalties that are effectively executed by courts. Higher penalties act as a deterrent and help to improve tax compliance. To achieve this goal, governments have to strengthen the rule of law and develop capacities of investigation authorities (Fishlow and Friedman, 1994).

Turnover tax collection is riddled with Corruption and Collusion among the Tax Administrators. A lack of clearly defined roles, functions, and duties of public officials creates an environment ripe for abuse. A high degree of discretionary power and the lack of adequate monitoring and reporting mechanisms are vital in providing opportunities for corruption. The greater the discretion, the greater the opportunity tax officials have to provide favourable interpretations of government rules and regulations to businesses in exchange for illegal payments (Pashev, 2005). Country-specific surveys in South Africa highlight that paying taxes, bureaucratic procedures attached to formalization, and government levies are among the main reasons for operating in the informal economy. In Kenya, research in rural villages done by Freeman, Ellis and Allison (2003) showed that villagers identified taxation as one of the most important barriers to achieving a satisfactory living.

In Pakistan, 67% of small businesses list tax regulations as most problematic, while 28% of SMEs felt that taxes in the country are too high (SMEDA, 2007). In Bulgaria, small businesses consider the tax burden to be the most significant barrier for their investment (Ahmet, 2002). In Ukraine, a survey showed that out of the four key problems hindering entrepreneurship, three were related to taxation: high tax rates; many different taxes; and frequently changing tax reporting (IFC, 2000). Golab (1996) argues that a flat tax system (replacing a number of tax instruments) would benefit small businesses the most.

First, because the compliance costs for such a system are far lower and this benefits small firms disproportionately. Second as tax credits and tax incentives tend to benefit larger, better connected and more influential firms. Their elimination therefore, allowing the introduction of a lower rate flat-tax, benefits smaller firms. Third, the increase in personal tax exemption benefits small businesses especially as many operate as sole-proprietors. Some versions of the flat tax include the exemption of dividends from taxable income, which eliminates the advantages accruing to debt finance.

The argument is that tailoring taxes on SMEs to bear into consideration these sentiments can make them more compliant. Some studies seemed to find challenges in the collection of tax from SMEs despite these hope-laden adjustments. SEATINI (2010) conducted a study that sought to find out the challenges facing tax revenue collection in Uganda (among other objectives) and came up with five pertinent challenges that were found to have serious impact on tax revenues. The challenges were: the biggest population of the workforce is found in agriculture or in small and informal enterprises which makes it difficult to impose taxes on them; tax evasion and avoidance practices contribute greatly to shrinking the country‟s taxable base; the limited capacity of revenue collecting agencies both at the central and local levels; and poor quality of basic data that can be utilized in tax collection.

Other than the challenges that face tax collection, studies have Other than the challenges that face tax collection, studies have shown that the tax collector and the taxpayer should work arm-in-arm to overcome some of the challenges. For instance, Brondolo (2009) conducted a study on the challenges facing tax collection and strategies and measures for responding to the challenges among EU countries during the global financial and economic crisis of 2008. The study posited that an economic downturn tends to worsen taxpayer compliance in important aspects.

Consequently tax agencies were encouraged to develop tax compliance strategies that are structured around two objectives: containing the growth in noncompliance and helping taxpayers to cope with the crisis. To achieve these objectives, four sets of measures were identified: expanding assistance to taxpayers; refocusing enforcement on the highest revenue risks; introducing legislative reforms that facilitate administration; and improving communication and outreach programs. A study conducted by DAC (2009), also found that the challenge for poor countries is not is not necessarily to tax more. How tax is raised matters, as well as how much. The challenge is to tax a larger number of citizens and enterprises more consensually.

This is not easy for various reasons, including economic structure and history. Despite repeated attempts at tax reform, the tax taken in some sources changes little from one year to another. This is attributed to Citizens‟ willingness to pay tax being low for historical, political or cultural reasons, implying a perception that governments consistently misuse public funds. It is difficult to collect tax from low income, agrarian economies, and to do so without resorting to coercion. Taxable units are small, so the costs of collection are high; and incomes are seasonal and unstable. Records are lacking, and there is limited use of banks. Collection depends on face-to-face interaction, where assessment and collection are done by the same people (thus increasing discretionary power and facilitating extortion). It is also difficult, and costly, to tax the large informal urban sector that exists in many developing countries. Away from the challenges facing the tax collector of turnover tax there are other studies that are against direct taxes directed towards the businesses in the informal economy.

A study by Ojeka (2011) found that Small and Medium Enterprises play a very important role in development of the Nigerian economy, making up about 97% of the entire economy. The research work sought to establish if any relationship exists between the growth of SMEs and the tax policy in Nigeria. It was found that most SMEs surveyed were faced with the problem of high tax rates, multiple taxation, complex tax regulations and lack of proper enlightenment or education about tax related issues. Although there was a general perception that tax is an important source of fund for development of the economy and provision of social services, the study revealed a significant negative relationship between taxes and the business‟ ability to sustain itself and to expand. A suggested solution by this study was increasing tax incentives through reducing tax rates and increasing tax authorities‟ support services towards small and medium enterprises.

In another study by Stern and Barbour (2005) on three countries (South Africa, Zambia and Rwanda) studied, Rwanda had the most flexible tax regime for small businesses. Small businesses with an expected turnover of less than the threshold of Rwf 20 million had the option of paying either corporate income tax of 30% or the presumptive tax of 4% on turnover. Under the presumptive regime, small businesses had the obligation of withholding PAYE (Pay As You Earn) and dividend tax. However, given their small size and their difficulty to maintain proper accounting records there was a great incentive to underreport turnover as well as to arbitrage between salaries and dividends. A presumptive turnover tax can simplify tax administration and compliance costs and hence benefit both tax administrators and taxpayers. However, a high turnover tax, such as that in Rwanda, may play a negative role by encouraging small firms to avoid paying the tax via under-reporting of gross revenues causing additional revenue authority auditing.

This interaction may form a vicious circle, diverting resources from both government and business to the „hide and catch‟ game. The result could be an unhealthy tax environment that encourages expansion of the informal economy (Stern and Barbour, 2005). Baurer (2005) argues that in carrying out their responsibilities, tax administrations can also create problems for the business community when they impose burdensome reporting and record keeping requirements; conduct excessive inspections and audits; fail to deal with corrupt tax administration employees; and, fail to provide transparency in tax administration operations. This type of environment harms individual businesses and the overall economy.

As a result, many in the business community react by taking steps which adversely affect the tax base. This typically includes underreporting profits and turnover; underreporting employee wages; and, by creating phantom employees. A significant number of businesses also fail to register or file tax declarations. This only increases the burden on those taxpayers who try to comply with the tax law, and discourages their future compliance. The result is a vicious cycle which tends to preserve the status quo. Only meaningful reforms to the tax system can break the cycle and result in an improved business climate which will stimulate economic growth.

From the literature review it is evident that the turnover tax which is a tax on SMEs is an unsettled matter. The manner to achieve success in the collection of tax from this sector is a challenge to both the developed and the developing countries. In addition to this, while some studies see this tax as necessary, others view it as an obstacle that hampers the growth of SMEs into the formal tax bracket.

Conceptual Framework

The revenue from the turnover tax is the dependent variable of this study. These revenues operationalize the ease of turnover tax collection. When the revenues are high then revenue collection is easy unlike when collections are low. The set of factors that have to be overcome are the independent variables. As shown in the figure below, the factors affecting TOT collection directly affect the TOT revenues. When the factors are many and difficult to overcome the revenues reduce and when they are few and easy to overcome revenues will be expected to be high. This happens within the context of the tax collection management policy of the tax collector. The tax collection management policy affects the nature and types of challenges, the revenue collections and the nature of the relationship between the challenges and the revenues (Rakner and Gloppen, 2002).

03 December 2019
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