TAXATION

Canons of Taxation

The word “canon”, in this sense, means a “fundamental principle”. Hence,

the canons of taxation are those fundamental rules which economists

today consider fundamental for designing an optimal tax system.

I. Adam Smith’s Canons of Taxation

Adam Smith, in his seminal work, ‘The Wealth of Nations’, propounded the

following four canons of taxation:

1. Canon of Equity: Adam Smith stated this canon, which is

founded on the moral principle of equity, as follows:

“The subjects of every state ought to contribute towards the

support of the Government, as nearly as possible, in proportion

to their respective abilities, that is, in proportion to their

revenue which they respectively enjoy under the protection of

the State." [emphasis added]

In other words, this, in practice means— every person should be subject to

the same tax rate.

This is to ensure that no taxpayer is treated unfairly.

2. Canon of Certainty: The quantum of tax, and the modalities of

paying it, must be certain (as opposed to arbitrary) to the taxpayer. This
necessarily implies that notice of such information should be given to every

taxpayer well in advance of the incidence of the tax in question.

This is to ensure that the effects of taxation, on the economy, are felt

effectively, for which such certainty is a condition-precedent. Certainty

about taxation allows taxpayers to allocate their resources accordingly, thus

giving effect to the effects of a tax in practice.

3. Canon of Convenience: It should be the constant endeavour of the

State to maximize the convenience, or ease, of paying the tax, for the

taxpayer.

This is to increase tax compliance, and therefore the revenues of the State

generated from taxes.

4. Canon of Economy: It should be the constant endeavour of the State

to minimize the cost of collecting the tax, vis-a-vis the net tax proceeds.

This is to ensure that the net revenue generated from a tax is maximized.

II. Modern Canons of Taxation

In addition to the aforesaid canons of taxation propounded by Adam Smith,

modern economists have added to the list a few more canons of taxation.

Some of them are:

5. Canon of Productivity: Taxes should be imposed such that, insofar

as practicable, it is a minimum disincentive against production, or a

maximum incentive for production. As a corollary, it necessarily follows that

tax incidence on that which contributes more to economic productivity

should be less, and vice-versa.

For instance, this implies that taxes on raw materials (as opposed to finished

products) should be minimal, as they are the inputs for a number of goods,

which change hands multiple times, and thereby contribute to economic

productivity to a larger extent (as opposed to finished products).

The object of this canon is to enhance economic productivity.

6. Canon of Elasticity: States use taxation as a policy tool. Whenever a

State changes the tax rate, it does so with an intended end in mind. This

canon states— insofar as possible, taxes should be as elastic as possible.

This means that the ability of the State to increase or decrease taxes as

required, and to thereby achieve the intended end, should be as unhindered

as possible.

For instance, as a corollary, it follows that higher taxes may be imposed on

inelastic goods and services. The less the elasticity of demand of the goods

and services in question, the less people will move away from consuming it

as a result of a higher tax— and the less will be the change in tax incidence.

In contrast, if it were more elastic, people would tend to move away from

consuming the goods in question as a result of a higher tax, thus negating

the effect of increasing the tax at all. 1

7. Canon of Diversity: The State should endeavour to impose a variety

of taxes on multiple classes of persons. 2

The justification is— this raises the

1 On the other hand, it is worthwhile to note— too high a tax on goods, and services, with
a low elasticity of demand is undesirable. Such goods, and services, tend to be
necessities. If too high a price is thus imposed on them, people nevertheless tend to
decrease their consumption of the same, which affects their health. Bad health is never
good for economic productivity.

2 On the other hand, it is worthwhile to note— increasing tax diversity increases the cost
of tax collection. This is undesirable, and needs to be balanced against the benefits
received from diversifying taxes.
certainty of generating revenue from taxes, as it is far more difficult to evade

multiple forms of taxes, as opposed to a single form of tax.

Types of Taxes – I

Taxes are broadly categorised into (1) direct, and (2) indirect, taxes, based

on the twin tests of (a) impact, and (b) incidence.

I. Tests of Impact & Incidence:

1. Impact: The impact of a tax is felt by the person on whom the burden

of paying the tax in question, to the government, is first imposed.

This person is responsible for collecting, and depositing, the tax in

question with the government.

2. Incidence: The incidence of a tax is felt by the person on whom the

final burden of paying the tax in question passed on to, and imposed,

in the end.

This is the person who cannot pass on the burden of the tax any

further.

II. Direct vs. Indirect Taxes:

Based on the impact, and incidence, of a tax, taxes are broadly categorised

into two, as follows:

1. Direct Taxes: The impact, and incidence, is on the same person. He is

the one who has to collect, and deposit, the tax with the government.

He cannot pass on the burden any further.

Examples: Income Tax, Wealth Tax, etc.

2. Indirect Taxes: The impact, and incidence, is on different persons.

While the final burden is imposed on one person, the first burden of

collecting, and depositing, the tax falls on someone else.

Examples: Goods & Services Tax, Sales Tax, etc.

Types of Taxation Systems

Tax Base— In economic terminology, tax base is the total assets, and

income, of a particular person which is taxed by the State.

Classification— On the basis of how tax rate of a person varies with his tax

base, taxation systems may be classified as follows.

1. Progressive Taxation: A system of taxation in which the tax rate of a

person increases as his tax base increases, and vice-versa.

For instance, an income tax regime with an increasing tax rate with

increasing income, is a system of progressive taxation. The income tax

system in India – wherein the income tax rate increases the higher income

tax slab one’s salary can be classified into – is a typical example.

Justification— Poorer people, vis-a-vis richer people, tend to spend a greater

share of their income on expenditure, leaving lesser left over to pay taxes.

Hence, progressive taxation shifts the burden of taxation from those can

afford to pay them less (i.e. the poor), to those who can afford to pay them

more (i.e. the rich).

2. Proportionate Taxation: A system of taxation in which the tax rate is

the same for every person, regardless of their tax base. Adam Smith

advocated such a system of taxation, in his canons of taxation.

Justification— There appears to be an inherent sense of fairness in taxing

everyone the same rate of tax.

3. Regressive Taxation: A system of taxation in which the tax rate of

person decreases, as their tax base increases.

Justification— A regressive taxation system enables trickle-down economics.

The reasoning goes: by taxing the rich less than the poor (in terms of the tax

rate), this enables more money in the hands of the rich (the top of the

pyramid), who then spend it on a variety of goods, and services, thus

making the money flow to the poorer people who serve them (the bottom of

the pyramid). This, proponents argue, is more efficient then putting this

money in State coffers, and asking it to redistribute it to the society. 3

3 As a critcal note— trickle-down economics was a theory propounded by the American

financial elite, probably for their own pecuniary interests. It is merely an ideology, and is
not supported by substantial economic theory, or evidence. In contrast, there is a
growing body of evidence that suggests that trickle-down economics does not work in
practice.
Measures of Tax Responsiveness

Inter alia, the effect of a tax, as a tool of public policy, is to bring about a

change in the behaviour of the people, and therefore the economy. Hence, it

becomes crucial to measure how much the market responds to a change in

tax rates. This is known as tax responsiveness.

Two major measures exist to measure tax responsiveness, appropriately

termed as measures of tax responsiveness. They are the following:

I. Buoyancy of Taxation

Definition— The buoyancy of taxation is the ratio of— (a) the percentage

change in tax revenue, to (b) the percentage change in the real GDP, of the

economy.

Limitation— Buoyancy of taxation is considered a comparatively inferior

measure of tax responsiveness, as it does not distinguish between

automatic, and discretionary, changes (see infra).

II. Elasticity of Taxation

Types of Changes in Tax Revenue— Changes in tax revenue may be

classified into two types:

1. Automatic Changes: Due to the effect of market forces, consumption

changes. Tax revenue changes proportionately. Such changes in tax

revenue are known as automatic changes— as they change

automatically, without any external human intervention.

 2. Discretionary Changes: The State is free to change the tax rate from

time to time. Tax revenue will accordingly change. Such changes in

tax revenue are known as discretionary changes— as they take place

at the discretion of the State.

Definition— The elasticity of taxation is the ratio of (a) the percentage

change in the tax revenue, caused by automatic changes, to (b) the

percentage change in the real GDP, of the economy.

Advantage— This measure distinguishes between market forces, and State

forces. Since the object of a measure of tax responsiveness is to measure

only the former, at the exclusion of the latter, it is comparatively a better

measure of tax responsiveness.