Justification for progressive taxation

Justification for progressive taxation

Even though higher taxation for the rich may be useful for purposes of raising revenues and reducing income inequality; it could spark behavioural responses such as tax evasion. The benefits of progressive taxation include creation of larger domestic savings, reduction of income inequality and strengthening of countercyclical economic forces (Weller and Rao, 2010). On the other hand, there are several negative effects of progressive taxation. These may include its potential to encourage tax evasion, forcing governments to spend more, and the influx of international capital investments (Diamond and Saez, 2011). Given that there are merits and demerits of progressive taxation, its applicability depends on whether the merits can outweigh the demerits. This paper takes the position that even though there may be negative impacts of progressive taxation, it is the best taxation policy for promoting economic stability in any given country.

From an economic point of view, the economy is said to be more stable where the disparity between the high income earners and the low income earners is low. Greater equality of incomes reduces the level of volatility in the market hence stabilising local demand (Steenekamp, 2012). This is due to the fact that lower income earners tend to have a higher marginal propensity to consume (Weller and Rao, 2010). Greater equality also contributes to enhanced social sustainability. The government is able to provide essential services such as healthcare and education. This improves the quality of life and provides a platform through which the poorer members of the society can acquire skills to develop the economy further. Social sustainability leads to economic stability where social unrest is minimised and the better-educated population is able to contribute more towards wealth creation. Educated populations tend to be more productive and creative. Progressive taxation is therefore good for economic stability.

The economic stability benefit of progressive taxation can also be experienced during the economic cycles. It does provide countercyclical forces. During economic boom, progressive taxation on the sections of the population making more is such that they are required to pay higher taxes (Weller and Rao, 2010). This reduces the amount of money available for additional speculation and this has the impact of reducing the severity of the boom. On the other hand, the reduction of the tax liability is highest on the high income earners during recessions. This also provides a countercyclical force hence aiding in the efforts to stabilise the economy. The more stable the economy, the higher the level of economic growth (Gruber and 2002). This relationship between economic stability and growth provides the justification needed for progressive taxation. As is expected, the rich are likely to benefit more from economic growth as businesses tend to grow exponentially when an economy is on an upward trend.

In spite of the benefits of progressive taxation, there have been challenges in its ability to raise additional incomes. The wealthier members of the society tend to receive a significant proportion of their income in formats that could be exempted from tax. For example, capital gains tend to be exempt from tax in most jurisdictions. This is in addition to tax breaks and flexible taxation for different classes of incomes. The rich are believed to be able to devise means through which they can evade taxation (Gruber and Saez, 2002). They tend to have numerous sources of income which range from salaries, dividends, and other forms of income. They are believed to utilise this diversity to shift their incomes into forms that are less taxable (Gruber and Saez, 2002). This behavioural response would reduce the ability of the government to raise higher tax revenues. This is in addition to its potential to discourage hard work. This disadvantage can however be overcome by embracing a tax regime that disallows most exemptions and tax breaks. These exemptions would then be compensated for by imposing a relatively lower tax rate on most forms of income.

There is also a psychological impact of progressive taxation. Progressive taxation has also been blamed for seemingly encouraging laziness and punishing the wealthy. While it may appear aimed to fight inequality, the taxation system is in itself a manifestation of inequality. The rich are forced to work harder to shoulder the weight of government than the rest of the society (Rodgers, 2013). This can send the wrong message to the population which would otherwise see entrepreneurship and hard work as the ideal way of growing their national economies. Even though this argument may sound sensible, proponents of progressive taxation state that the wealthy would find greater rewards for their hard work if more income is spent on the poor through taxation. By facilitating cheaper shelter and essential services, government helps in boosting the spending power of the population (Steenekamp, 2012). This in turn leads to higher demand for their products hence leading to greater profitability of their businesses. Besides, enhanced economic stability favours the rich greatly where their businesses are able to thrive.

Progressive taxation can lead to an influx of foreign investors in an economy. The taxation system could reduce the amounts of income available for investing hence creating an opportunity for international investors to come in (Weller and Rao, 2010). While this may be acceptable economically, it may pose challenges politically. The aim of any political class is to ensure that the locals are in charge of the economy to the greatest extent. This forms the rationale for most countries introducing tax breaks and exemptions that insulate many investors from taxation. This argument may seem retrogressive in the globalisation era where international trade is highly encouraged. However, the realities for local populations may be different. Capital flight leads to higher unemployment levels. This in turn leads to reduced demand hence discouraging local investments further. This could set a downward trend in the economy and progressive taxation is the best approach to stem it.

An alternative to progressive taxation is the flat tax system. This system has been advocated for in political discussions in the USA with the wealthier members of the society being largely in favour of the same (Rosenfelder, 2012). With flat tax, every member of the society pays a fixed rate of their income. This would ensure that all members of the society share the tax burden equally irrespective of their income levels. This would however have far reaching implications on the stability of demand within a country. Adopting a flat tax would imply the need to lower the existing taxes on the rich and impose them on the poorer sections of the society (Steenekamp, 2012). From the perspective of the wealthy, this would have the impact of stimulating entrepreneurship and investment. On the other hand, it would reduce the demand levels in the market as the lower income earners who are more sensitive to changes in income would be having less money. With additional incomes and suppressed local demand, local investors would be tempted to invest more in the international markets. The resultant capital flight could have a spiral effect hence leading to economic instability.

In recommending progressive taxation, it is important to provide a justification for it and how to overcome its negative effects. Its capacity to prompt a behavioural response in favour of less taxable income forms can be overcome by introducing some level of uniformity. Removal of tax breaks and exemptions would level the playing field. While this could have the impact of discouraging investment in the targeted areas, an alternative incentive can be provided that would not involve the design of the taxation regime.  Besides, progressive taxation offers greater benefits in its ability to promote economic stability. It also provides governments with the ability to raise incomes without adversely impacting the local demand. As has been argued above, the marginal propensity to consume is higher among the lower-income earners. The higher income earners on the other hand are able to keep up their spending despite slight changes in their incomes. From the arguments raised above, progressive taxation approach is preferable for economies.

In conclusion, the merits of a progressive regime can be said to be higher than the demerits. It aids in economic stability and provides governments with a means of adding revenues without adversely affecting local demand. It also helps in reducing income inequality by taxing the rich more and using the incomes to provide essential services that the poor are able to access at a reduced fee. The demerits of the same include prompting behavioural responses towards tax evasion and discouragement of hard work in the society. These demerits can easily be overcome by redesigning the taxation regime to eliminate loopholes for tax evasion and through public education to reverse any view that the system punishes hard work. Having compensated for the demerits of the system, it is logical to conclude that it is an ideal taxation system for any country.   

References

Diamond, P. & Saez, E. (2011). The Case for a Progressive Tax: From Basic Research to Policy Recommendation. The Journal of Economic Perspectives 25(4): 165-190

Gruber, J. & Saez, E. (2002). The elasticity of taxable income: evidence and implications, Journal of Public Economics, 84, pp. 1–32

Rosenfelder, M. (2012). Why the rich should pay more taxes. Retrieved November 16, 2013 from: http://www.zompist.com/richtax.htm

Steenekamp, T.J. (2012). Taxing the rich at higher rates in South Africa? South African Business Review, 16(3), pp. 1-29

Weller, C.E. & Rao, M. (2010). Progressive Tax Policy and Economic Stability. Journal of Economic Issues 44(3): 629-659