Who should be taxed, how should they be taxed and what purpose should it serve? These questions are as old as the world.
To help answer them, in his 1776 work “The Wealth of Nations” the Scottish economist and philosopher Adam Smith formulated four principles of taxation. According to him, taxes should be proportional to the benefits that a person derives from belonging to society. IIt is similar to the “cost of governance” borne by the shareholders of a particular company – the taxpayers. Thus, Smith is not opposed to obligations such as a luxury tax. Larger shareholders contribute more, smaller ones less.
Equally important is another principle of taxation: the tax that each person pays must be clear, and the taxpayer must know how much, when, and how they will have to pay. There can be no arbitrariness on the part of the tax authorities or the public authorities. Taxes that are known and predictable in advance allow people to plan investments, increase productivity, and feel secure.
Upholding this principle helps taxpayers avoid confusion over tax laws, interpretations, and declaration forms. It reduces the administrative burden by making it easier for them to calculate, declare, and pay their tax obligations. Otherwise, there is a risk that the taxpayer may be taken advantage of, with tax obligations imposed “from above,” and penalties are imposed if they are not complied with. This risk increases if the rules governing the imposition of taxes become more complex, are frequently amended, and extended.
Smith’s third principle of taxation is similar but no less important: ‘every tax should be levied at the time or in the manner most convenient for the taxpayer to pay it’. The more convenient the process, the more resources the taxpayer can devote to value creation.
Tax administration should not have a negative impact on the allocation and use of resources in the economy, and certainly should not cost more than the tax itself. This is the fourth principle of taxation.
“Every tax should take as little as possible out of people’s pockets and stay as far away from them as possible, in order to avoid unrealized revenue due to the burden of taxation, the distortions it creates and the negative incentives it creates“, writes Mr. Smith.
The inefficient allocation of resources in an economy can be born out of the excessive costs of collecting and administering taxes. It can also be caused by a significant reduction in a firm’s production capacity as a result of higher taxation of products in demand. Worst of all, increased tax burdens lead individuals and businesses to avoid taxes and to retreat into the shadow economy. Good intentions sometimes have negative consequences: the desire to increase tax revenue leads to a loss of revenue.
Why is it important to talk about Smith’s principles of taxation even after almost a quarter of a century? Because they remind us that taxpayers have rights as well as duties. For example, the right to an efficient and stable tax system. In other words, the tax system should not impose excessive burdens on the government and taxpayers, and the latter must be able to prepare for tax changes.
And while they may seem declarative, taxpayers’ rights do work, and the extent to which they are respected is a measure of the relationship that public authorities are building with their citizens. Is the taxpayer seen as a customer or a servant?
For example, the tax package presented by the Lithuanian Ministry of Finance included additional personal income tax rates of 5% and 7% on joint income. This is a rule that would penalize higher-income earners, increase the tax and administrative burden and lead to an inefficient allocation of resources in the economy. The opposite should be true: taxes provide for the basic needs of society, but their burden does not constrain economic activity.
This condition was not taken into account in the adoption of the law on the windfall profits tax on banks. Whatever it is called, it is a tax that will inevitably lead to an inefficient use of resources, reducing the banks’ resilience to crises due to a significant reduction in reserves. The urgent adoption of this law also shows a serious disrespect for taxpayers – laws providing for new taxes must be adopted at least six months before they come into force – and violates their fundamental rights to prepare for a new tax burden and to plan the distribution of their tax burden.
In light of these tax changes, the inconsistency and unpredictability of the Lithuanian tax system are becoming more pronounced. This will inevitably change the behavior of taxpayers in planning and allocating their tax burden in Lithuania. And perhaps even abroad.
Whatever the case, the groundwork has already been laid. Almost 250 years ago, Adam Smith paved the way for a sustainable, stable, and efficient tax system. It is up to us to follow it.
Written by Reda Simonaitytė – an expert at Lithuanian Free Market Institute.
The article was originally published at IQ magazine.