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Principles of Taxation:
According to John Stuart Mill( 19th century Economist), the four
principles of taxation are that the system be efficient, understandable and
equitable and those who benefit from publicly-provided services should
sponsor and pay for those services through taxes. A good tax system
follows the four principles of taxation.
The first principle, efficiency, means that the tax system raises enough
revenue to sponsor projects without burdening the economy and the
system shall not become a disincentive for performance. According to
Wikibooks, the second principle of "understandable" means that the
system should not be incomprehensible to someone who does not
understand the principles of taxation. The tax system should not have
hidden or complicated language that the average citizen cannot
understand, and all costs should be upfront and transparent.
Thirdly, the tax system must be equitable, notes Wikibooks. This means
that taxation should be determined by a person's ability to pay, and that
wealthier people should pay more in taxes because they are able to do
so. This specific principle is also known as a flat tax rate. For example, a
tax of 10 percent would have far less of an impact on a person who
makes a million dollars a year than on someone who makes $10,000.
The fourth principle, the benefit principle, simply means that those who
benefit from a publicly provided service should pay the taxes that fund
the service.
Principles of Taxation
The following were first proposed by the great economist Adam Smith,
and are still applicable today, although many other economists have
added and improved on his theories:

1. Efficient - A tax system should raise enough revenue such that

government projects can be adequately sponsored, without
burdening the tax payer too much, or disincentivising investment
or work
2. Understandable - The system should not be incomprehensible to
the layperson, nor should it appear unjust or unneedfully complex.
This is to minimise discontent, and costs.
3. Equitable - Taxation should be governed by people's ability to
pay, that is, wealthier individuals or firms with greater incomes
should pay more in tax while those with lower incomes should pay
comparatively less.
4. Benefit Principle - Those that use a publicly provided service
(which is funding primarily through taxation) should pay for it!
However, conflicts in principle may and often do arise between
this and principle 3.
Pg. 37
Horizontal and vertical equity examples
While the discussion between horizontal and vertical equity generally
applies to tax policy, we can also look at the class economics definition
for the two terms and go over a few examples.

Horizontal equity means that we apply the exact same policy to people
in the same situation. For example if two people earn both earn $25,000
per year they should both pay the same amount of tax. This means that if
we have horizontal equity, we try to make sure that we do not make
decisions based on non-income characteristics like ethnicity, gender,
weight, sexual orientation, or job status.

Vertical Equity means that people with higher incomes should be

required to pay more tax. The purpose of vertical equity is to to tax in a
more progressive way. It goes by the principle that people with more
ability to pay should pay more. The point of vertical equity is to
redistribute wealth in the society in a more fair way, which implies
that poor people get more happiness out of money than the rich do.

Horizontal equity is a must for most tax systems because citizens can
become very upset if they are required to pay higher taxes based on non-
financial characteristics such as marriage. Before the recent reform,
married couples filing together in the United States paid more in taxes
than an identical married couple would by filing separately. Consider
the following example of horizontal equity:
John and Jane file together, and make 50K each. Because together they
earn 100K, they fall into the 20% tax bracket, and pay 20K in
taxes. While Adam and Alice file separately, because they each 50K
each, they fall in the 10% tax bracket, and pay only 10K in taxes
total. Because these people are in identical situations but pay different
tax amounts, we see a violation of the horizontal equity principle.

What the recent tax reform did was raise the amount of income allowed
by married couples, so that people in John and Janes situation would
pay an identical amount to couples in Adam and Alices situation. This
results in horizontal equity.

An example of a violation of vertical equity is a tax on food. Generally

people (both rich and poor) will buy a similar amount of food each
month. This means that both rich and poor will pay the same amount of
tax on their food purchases. This violates the vertical equity principle
because those who are able to pay more are not required to.

An example of vertical equity is the progressive federal income tax

system in the United States. As someone earns more money, they have
to pay a higher percentage of their income in taxes. While those with
low incomes, pay lower percentages of their income in tax, or perhaps
pay no tax at all
Redistributive Tax: A tax that is intended to spread incomes more
fairly among people, by taxing rich people more and poor people less

Pg. 42
Tax Cascading
DEFINITION of 'Cascade Tax'
A tax that is levied on a good at each stage of the production process up
to the point of being sold to the final consumer. A cascade tax is a type
of turnover tax with each successive transfer being taxed inclusive of
any previous cascade taxes being levied. Because each successive
turnovers includes the taxes of all previous turnovers, the end tax
amount will be greater than the cascade tax rate.


Cascade tax can create higher tax revenues compared to a single stage
tax, because tax is imposed on top of tax.

For example, a government levies a 2% cascade tax on all goods

produced and distributed. A company sells $1,000 worth of stone for a
tax-inclusive price of $1,020 ($1000 + 2% cascade tax) to an artist. The
artist makes a sculpture out of the stone and wants to make $2,000 when
he sells it to an art dealer, so he adds this figure to what he paid for the
stone to get $3,020, and then adds on the cascade tax to bring the total to
get $3,080 ($3020 + 2%). The art dealer wants to make $5,000 for the
sculpture, adding this to $3,080 for a pre-tax $8,080. She then adds the
2% cascade tax for a total price of $8,242. The government collected
taxes of $242, which is actually a rate of 3.025% ($242/$8,000).

Input tax credit
You cant punish a man twice for the same crime, says the law.
Shouldnt the same principle apply to taxation of goods and services?
Enter input tax credit. The basic premise is that taxing the same thing
twice is not fair.

So, to avoid double taxation on items used as inputs to make other items,
credit of taxes paid on the inputs can be taken by the maker of the next
item while paying tax on the output. If the tax paid on inputs is higher
than the tax on the output, the excess can be claimed as a refund.

All dealers are liable for output tax on taxable sales done in the process
of his business. With the help of input tax credit, he can offset the output
tax against the input tax already paid.
Tax offsets, sometimes referred to as rebates, directly reduce the amount
of tax payable on your taxable income. In general, offsets can reduce
your tax payable