7.3 Tax Fairness and Tax Efficiency

We’ve just seen how economic analysis can be used to determine the inefficiency caused by a tax. It’s clear that, other things equal, policymakers should choose a tax that creates less inefficiency over a tax that creates more. But that guideline still leaves policy-makers with wide discretion in choosing what to tax and, consequently, who bears the burden of the tax. How should they exercise this discretion?

One answer is that policy-makers should make the tax system fair. But what exactly does fairness mean? Moreover, however you define fairness, how should policy-makers balance considerations of fairness versus considerations of efficiency?

Two Principles of Tax Fairness

Fairness, like beauty, is often in the eyes of the beholder. When it comes to taxes, however, most debates about fairness rely on one of two principles of tax fairness: the benefits principle and the ability-to-pay principle.

According to the benefits principle of tax fairness, those who benefit from public spending should bear the burden of the tax that pays for that spending.

According to the benefits principle of tax fairness, those who benefit from public spending should bear the burden of the tax that pays for that spending. For example, those who benefit from a road should pay for that road’s upkeep, those who fly on airplanes should pay for air traffic control, and so on. The benefits principle is the basis for some parts of the Canadian tax system. For example, the federal Gas Tax Fund specifically reserves a portion of federal taxes collected on the sale of gasoline and diesel fuel for the maintenance and improvement of municipal infrastructure projects. In this way motorists who benefit from the use of public roads also pay for it. Another example is the Air Travellers Security Charge (ATSC) that channels all ATSC payments collected from air travellers to pay for enhancements to and the operation of the air security system at 89 airports in Canada.

The benefits principle is attractive from an economic point of view because it matches well with one of the major justifications for public spending—the theory of public goods, which will be covered in Chapter 17. This theory explains why government action is sometimes needed to provide people with goods that markets alone would not provide, goods like national defense. If that’s the role of government, it seems natural to charge each person in proportion to the benefits he or she gets from those goods.

According to the ability-to-pay principle of tax fairness, those with greater ability to pay a tax should pay more tax.

Practical considerations, however, make it impossible to base the entire tax system on the benefits principle. It would be too cumbersome to have a specific tax for each of the many distinct programs that the government offers. Also, attempts to base taxes on the benefits principle often conflict with the other major principle of tax fairness: the ability-to-pay principle, according to which those with greater ability to pay a tax should pay more.

The ability-to-pay principle is usually interpreted to mean that high-income individuals should pay more in taxes than low-income individuals. Often the ability-to-pay principle is used to argue not only that high-income individuals should pay more taxes but also that they should pay a higher percentage of their income in taxes. We’ll consider the issue of how taxes vary as a percentage of income later.

Discussions on government policy issues often use the ability-to-pay principle as a means to argue either for change or in support of the status quo. For example, during debates about Canadian municipal property taxes complaints are commonly made that the residential property tax system is “unfair” because the tax is a percentage of the value of a property. The fact that one house is worth $500 000 while another is worth $250 000 does not imply that the former creates a burden on municipal services that is twice as large. The tax violates the benefits principle of tax fairness. But that is not the end of it. During such debates, one often also hears that just because a senior citizen owns a home worth $500 000 does not imply they have the ability-to-pay a large property tax amount. So this tax also violates the ability-to-pay principle, which may force “lucky” seniors, who have had the good fortune to see their home value rise significantly over time, to sell their homes so as to live within their income.

Equity versus Efficiency

Canadian taxes on the manufacture and retail sale of alcohol are complex. In general, most provinces require makers to have a special manufacturer licence, the cost of which is a flat fee or tax paid by both large and small producers. This is an example of a lump-sum tax, a tax that is the same regardless of any actions people take. In this case, the large producers pay the same amount of tax regardless of how many litres they produce. Lump-sum taxes are widely perceived to be much less fair than a tax that is proportional to the amount of the transaction. Small producers may feel that they should pay less tax than much larger producers pay. If the fixed licensing fee is set quite high then some smaller producers may find their profit maximizing response is to shut down their firm.

A lump-sum tax is the same for everyone, regardless of any actions people take.

But provincial and territorial alcohol taxes applied on retail sales are usually levied on what is essentially a per-litre basis, which definitely distorts incen tives to engage in mutually beneficial transactions and creates deadweight loss. Because of these alcohol sales taxes, some producers will reduce how much alcohol they make, with some forgoing production altogether. The result, surely, is a lower production of alcohol and less income earned by manufacturers and employees in the alcohol sector because of these sales taxes.

In contrast, a lump-sum tax does not distort incentives. Because under a lump-sum tax people have to pay the same amount of tax regardless of their actions, it does not lead them to change their actions and therefore causes no deadweight loss. So lump-sum taxes, although unfair, are better than other taxes at promoting economic efficiency.

A tax system can be made fairer by moving it in the direction of the benefits principle or the ability-to-pay principle. But this will come at a cost because the tax system will now tax people more heavily based on their actions, increasing the amount of deadweight loss. This observation reflects a general principle that we learned in Chapter 1: There is often a trade-off between equity and efficiency. Here, unless a tax system is badly designed, it can be made fairer only by sacrificing efficiency. Conversely, it can be made more efficient only by making it less fair. This means that there is normally a trade-off between equity and efficiency in the design of a tax system.

In a well-designed tax system, there is a trade-off between equity and efficiency: the system can be made more efficient only by making it less fair, and vice versa.

It’s important to understand that economic analysis cannot say how much weight a tax system should give to equity and how much to efficiency. That choice is a value judgment, one we make through the political process.

FEDERAL TAX PHILOSOPHY

Every year, Canadians use the T1 Schedule 1 form to calculate the amount of federal taxes that they owe.

What is the principle underlying the federal tax system? (By federal, we mean taxes collected by the federal government, as opposed to the taxes collected by provincial, territorial, and local governments.) The answer is that it depends on the tax.

The best-known federal tax, accounting for about half of all federal revenue, is the personal income tax. The structure of the income tax reflects the ability-to-pay principle: families with low incomes pay little or no income tax. In fact, some families pay negative income tax: a program known as the Working Income Tax Benefit “tops up,” or adds to, the earnings of low-wage workers. Meanwhile, those with high incomes not only pay a lot of income tax but also must pay a larger share of their income in income taxes than the average family.

Alongside the personal income tax system that generally flows money from individuals to governments in the form of tax payments is a system of government personal transfer payments that flow money in the other direction. Since transfers flow from governments at all levels to individuals, they are like a tax but with a negative (tax) rate. Major transfer programs exist for old age security benefits and for children’s benefits payments. The Old Age Security (OAS) is Canada’s first public pension plan established in 1927. Today the OAS is a taxable monthly pension entitlement available to most Canadians 65 years of age or older. Canadian seniors living with low income or who are widowed may qualify for further supplemental payments to help raise their standard of living. In 2013, about $40 billion in regular and supplemental OAS payments were paid to Canadian seniors. This far eclipsed the $13 billion in government transfers in the form of children’s benefits payments made to assist people with the cost of raising a young family.

These transfer payments are financed out of general government revenues and have built-in reductions. In order to qualify either for a larger amount or even a payment at all, the potential recipient must have an income below some set threshold. This ensures that larger payments are directed to those who need them the most, while keeping transfer program expenses down, which helps keep the program affordable.

TABLE7-2 Share of Pre-Tax Income, Income Tax, and Government Transfers, by Quintile in 2011

Table 7-2 illustrates the difference in which families bear the burden of income taxes (to the federal and provincial/territorial governments) and which families receive government transfers. The table divides Canadian families into quintiles, based on after-tax income: the bottom quintile is the poorest 20% of families after income taxes have been paid; the second quintile is the next poorest 20%, and so on. The second column shows the share of total Canadian pre-tax and pre-transfer income received by each quintile. The third column shows the share of personal income tax collected that is paid by each quintile.

As you can see, low-income families earn little income and pay even less income tax. Even middle-income families paid a substantially smaller share of total income tax collected than their share of total income. In contrast, the fifth or top quintile, the richest 20% of families, paid a much higher share of total federal income tax collected compared with its share of total income. The fourth column shows the share of total government transfers that is received by each quintile, and the results are very different: the share of total transfer payments received by the bottom two quintiles is well above their share of income received and slightly above their share of the population. Plus the share of transfers received by the top quintile is substantially less than its share of total income. It is the only quintile that really falls short of a 20% share.

Generally transfer payments are financed out of general government revenues. But the burden of personal income taxes falls more on higher-income earners. At the same time, high-income families do not get an equal share of the transfer payments distributed, despite providing most of the funds needed for these programs. So the beneficiaries of government transfers in the form of OAS and children’s benefits (i.e., seniors and low-income families with young children) do not bear the tax burden necessary to support this spending. Thus the design of these transfer programs does not adhere to the benefits principle. Instead the funding, and distribution of transfers, adheres to the ability-to-pay principle. As a society, we have decided to spread the costs of these government transfer programs unequally across all taxpayers.

Quick Review

  • Other things equal, government tax policy aims for tax efficiency. But it also tries to achieve tax fairness, or tax equity.

  • There are two important principles of tax fairness: the benefits principle and the ability-to-pay principle.

  • A lump-sum tax is efficient because it does not distort incentives, but it is generally considered unfair. In any well-designed tax system, there is a trade-off between equity and efficiency. How the tax system should weight equity and efficiency is a value judgment to be decided by the political process.

Check Your Understanding 7-3

CHECK YOUR UNDERSTANDING 7-3

Question 7.8

Assess each of the following taxes in terms of the benefits principle versus the ability-to-pay principle. What, if any, actions are distorted by the tax? Assume for simplicity in each case that the purchaser of the good bears 100% of the burden of the tax.

  1. A federal tax of $500 for each new car purchased that finances highway safety programs

  2. A local tax of 20% on hotel rooms that finances local government expenditures

  3. A local tax of 1% on the assessed value of homes that finances local schools

  4. A 1% sales tax on food that pays for government food safety regulation and inspection programs

  1. Since drivers are the beneficiaries of highway safety programs, this tax performs well according to the benefits principle. But since the level of the tax does not depend on ability to pay the tax, it does not perform well according to the ability-to-pay principle. Since higher-income car purchasers are likely to spend more on a new car, a tax assessed as a percentage of the purchase price of the car would perform better on the ability-to-pay principle. A $500-per-car tax will cause people to buy fewer new cars, but a percentage-based tax will cause people to buy fewer cars and less expensive cars.

  2. This tax does not perform well according to the benefits principle because the payers are non-residents of the local area, but the beneficiaries are local residents who will enjoy greater government services. But to the extent that people who stay in hotels have higher income compared to those who don’t, the tax performs well according to the ability-to-pay principle. It will distort the action of staying in a hotel room in this area, resulting in fewer nights of hotel room stays.

  3. This tax performs well according to the benefits principle because local homeowners are the users of local schools. It also performs well according to the ability-to-pay principle because it is assessed as a percentage of home value: higher-income residents, who own more expensive homes, will pay higher taxes. It will distort the action of buying a house in this area versus another area with a lower property tax rate or the action of making changes to a house that increase its assessed value.

  4. This tax performs well according to the benefits principle because food consumers are the beneficiaries of government food safety programs. It does not perform well according to the ability-to-pay principle because food is a necessity, and lower-income people will pay approximately as much as higher-income people. This tax will distort the action of buying food, leading people to purchase cheaper varieties of food.