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Designing a Tax System that Reflects Good Policy
So, what makes for “good” tax policy as opposed to “bad” tax policy? If you think it is straightforward to design a simple, effective tax system, you would be mistaken. Economic and political pressures have enormous influence, so the characteristics of good tax policy are critical guiding principles.
By Jonathan Liss
So, what makes for “good” tax policy as opposed to “bad” tax policy? This is the million-dollar question, or more likely the trillion-dollar question these days. If you think it is relatively straightforward to design an effective tax system based solely on good tax policy, you would be mistaken. Economic and political pressures have enormous influence on taxation, so incorporating all characteristics of good tax policy can be difficult to achieve in reality. In this blog, I will briefly describe the guiding principles of good tax policy, highlighting adequacy, neutrality, fairness, efficiency, and government accountability.
Adequate Government Revenue
An effective tax system must be able to raise adequate revenue to pay for government services and programs for both current and future needs. This typically requires a mix of tax types, such as income, property, and/or sales and use taxes. According to the American Institute of CPAs (AICPA), “Different types of taxes are affected differently by changes in the economy. For example, in an economic downturn … income tax revenues will decline. If the government is collecting other types of taxes that are less affected by decreased employment or if the effect will not occur as quickly, government revenues in total are less adversely affected than if the government relied solely on an income tax.”1
A tax system should be flexible so that it meets the current revenue needs of government while adapting to changing needs on a continuing basis. It must also be stable to ensure that a consistent level of revenue is collected by the government. Policymakers should strive for stability and predictability by minimizing the frequency of tax law changes and avoiding the enactment of temporary tax laws.
Tax Neutrality
Ideally, taxes should have little or no effect on business and individual decisions. According to author David Brunori, “Market conditions and economic efficiency – not the tax code – should dictate business decisions. Similarly, taxes should not be used to influence individual consumption choices.”2 The tax tail shouldn’t wag the dog, so to speak. Tax neutrality can best be achieved by ensuring the tax has a broad base, with few preferential tax credits and exemptions, and a low rate. Currently, many taxes imposed at the state and local level deviate from principle of tax neutrality.
Fairness
A tax system should be fair and equitable. In designing a fair tax system, two principles of equity should be kept in mind:
Horizontal equity – A tax system should treat taxpayers who are similarly situated the same. Although some groups may receive preferential treatment (such as low-income taxpayers or senior citizens), the overall tax system must be equitable. In other words, horizontal equity means that two taxpayers with equal abilities to pay should pay the same amount of tax.
Vertical equity – A tax system should be based on one’s ability to pay. Individuals within a higher income group should pay tax at a higher rate than those in a lower income group. However, the AICPA observes, “How much more tax to pay is a common topic of debate and, over the decades, has resulted in a variety of ranges of graduated tax rates and exemption amounts leading to varying levels of progressivity of the tax systems.”3
Effective Tax Administration
A well-designed tax system will minimize the costs to collect taxes. This includes both the cost of administration for the government and taxpayer compliance costs. For taxpayers, such costs include reporting their tax liabilities to the taxing authority (i.e., filing tax returns) and paying the taxes. Administrative costs incurred by government include processing returns and payments, enforcement, and taxpayer assistance. The greater the taxpayers’ cost of compliance, the higher the government’s cost of enforcement will be.
The cost of compliance for certain types of taxes is much greater than others. For example, management of state and local sales tax recordkeeping and reporting requirements are challenging for multistate businesses. Sales taxes are typically filed and remitted on a monthly basis, which can be a significant compliance burden for taxpayers who do business in many states.
Government Accountability
A government should have an open and transparent tax system that treats all taxpayers the same, while ensuring the timely collection of taxes. It is necessary for taxpayers to have complete access to all current tax laws, regulations, and rules. There should be no secret government policies. A part of government accountability is studying the existing tax system and recommending ways to improve its efficiency and equitability. The public should be kept aware of tax reform initiatives and understand any proposed changes in order to promote debate.
In designing a tax system, applying the guiding principles of good tax policy can often be quite challenging. In many cases, policymakers use the tax law to implement social and economic policies that are not consistent with government’s primary purpose of raising adequate revenue. Frequent tax law changes are also an impediment to achieving these principles.
For more on evaluating good tax policy, download PICPA’s Guiding Principles of Good Tax Policy brochure.
1 American Institute of CPAs, Tax Policy Concept Statement No. 1 – Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals (2017).
2 David Brunori, State Tax Policy: A Political Perspective, Urban Institute Press.
3 American Institute of CPAs, Tax Policy Concept Statement No. 1 – Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals (2017).
Jonathan Liss is senior revenue policy analyst with the Philadelphia Department of Revenue and an adjunct professor at Drexel University and Villanova University Charles Widger School of Law. He can be reached at jonathan.liss@phila.gov.
For a Q&A with Jonathan Liss on the Philadelphia Department of Revenue's online Tax Center and more tax information, visit PICPA's Tax Resources for CPAs page.
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