Taxes in Practice

• Author: Ruud De Mooij and Michael Keen
• Position: a Deputy Division Chief and Michael Keen is a Deputy Director, both in the IMF's Fiscal Affairs Department.

Back to Basics

Tax policy is often guided by simple rules of thumb. Sometimes, they are strikingly right. But sometimes they can be dangerously misleading.

There is an adage, for example, that “an old tax is a good tax.” That may be true for, say, the property tax. But taxes on windows and beards are long gone, import tariffs are in decline, and new levies, such as the value-added tax, have gained ground. Designing a good tax system requires more than a good slogan.

We dealt before with the basic principles of taxation (see “Back to Basics” in the December 2014 F&D). Now we apply them to some central and current tax policy debates.

Personal income

The great appeal of the personal income tax is that it taxes people on an indicator of their ability to pay, collecting progressively more from those with higher incomes. But the indicator is imperfect, because the government cannot be sure whether a high income results from intrinsic talent or luck—which will not be affected by taxation—or hard work and creativity—which might be. Taxing income might not only discourage effort (not just hours worked, but also, for example, entrepreneurial activity and striving for promotion), but can also give rise to tax avoidance and evasion.

The design of the personal income tax, therefore, revolves around a fundamental trade-off: progressive taxes support equity objectives, but can reduce efficiency. As long as people have differing views on what is equitable, there will never be universal agreement on the best tax schedule. But careful theory and empirical evidence have illuminated key considerations.

There is, for instance, the need to consider not only the personal income tax but all taxes and all income support measures—such as the Earned Income Tax Credit in the United States, which gives money to low-wage workers in amounts gradually reduced as income increases. Income support is simply negative income taxation and, when withdrawn as income rises, acts just like a tax on that additional income.

There is indeed a strong case for subsidizing earnings of low-wage workers, because their willingness to work is particularly sensitive to tax, and it is cheaper to ensure their well-being when they are working. But while the average tax rate at the bottom will therefore typically be negative, the effective marginal rateâthe additional tax paid (or benefit not received) when income rises by one dollarâshould be positive. Otherwise the subsidy will...