Revenue
Tax has four key purposes, which are often referred to as ‘The Four Rs of Tax’. The first of these is generating revenue, or government income. This revenue provides three functions:
1) It is used to fund essential public services like education & healthcare, as well as infrastructure like roads, street lights, & bins.
2) It is also related to the strengthening of the democratic process, because when governments receive revenue via tax, it places the citizens of that country in a position whereby they can demand to have an input into how the revenue is spent. Tax is therefore related to democracy.
3) It provides governments with the predictability needed to be able to make financing decisions into the future. For example, if a government was using only aid to pay the salaries of all nurses, doctors & teachers, what would happen if that aid were to be removed?
Redistribution
The second purpose of tax is to support the redistribution of wealth. Redistribution refers to redistributing the country’s resources from the wealthy towards the poorest & most vulnerable people, which can help to reduce inequality in society. This is seen as an ‘active’ fiscal policy and is in line with the Keynesian school of economic thought.
However, redistributing wealth via tax can be done in a number of ways, & not all are equally just. In fact, the way a country’s citizens are taxed can either lessen or increase equality. Therefore the already existing income inequality means that it is not solely enough to increase the amount of tax, instead governments must decide how to tax its population in order to ensure an equitable burden that does not worsen existing inequality.
Specifically, there are two ways in which tax can be applied on individuals in society that can lessen or increase income inequality. These two ways are progressive or regressive. A reliance on consumption taxes like sales tax or value added tax (VAT), for example on food or fuel is seen as regressive as everybody is taxed the same amount regardless of their financial status. In contrast, an example of a progressive tax is income tax in some countries, as index bands change the tax rate based on how much income is earned, & the more people earn, the more tax they pay (to a point). This is because the marginal utility (i.e. the usefulness of the surplus) is lower as one earns more money . For example, when a person has less money, each unit of that money becomes more valuable. Think about it; the marginal utility of €10 to a person earning €4,000 per month is much greater than to a person earning €10,000 per month.
Repricing
The third purpose of tax is the repricing of certain goods. Items may be taxed according to whether they constitute a public ‘good’ or public ‘bad’. Tax can be applied to create a price that accurately reflects the benefits & costs to society. For example, higher taxes on cigarettes & alcohol may discourage their use, both of which are negative for people’s health, while tax breaks on the price of bicycles or electric vehicles may incentivise people to choose these modes of transport that are better for the environment & human health. In this way, tax can be used to deter behaviours that are considered socially undesirable, & can be used to incentivise behaviour that is considered desirable to society.
Representation
The final R of taxation is representation. Citizens & other entities are generally only required to pay taxes if the taxing authority provides them with a political voice via elected representatives. The relationship of taxation to representation goes back to the time before the American Revolution. At the time, the anti-British slogan “Taxation without representation is tyranny” reflected the resentment of American colonists at being taxed by the British parliament, a political body to which they elected no representatives. Tax can therefore build healthier democracies, because as populations are taxed, they tend to demand stronger political representation & governance. This dynamic has contributed to the emergence of what is known as the ‘social contract’ or ‘fiscal contract’, whereby tax-paying members of society vote for certain candidates & in doing so expect them to raise & spend the taxpayer’s revenue in a way that benefits the voter. A study found that in 113 countries between 1971 & 1997, introducing or increasing taxes without simultaneously increasing or improving service delivery led to citizens demanding their rights, & to subsequent democratic reforms. This trust given to authorities by citizens when paying tax is important for building a shared accountability between citizens & governments. However this trust is threatened by a perception of unfairness, which tends to increase when ordinary citizens feel that they are paying too much, while the richer players are not contributing their fair share.
Stability
Another purpose of tax is (macroeconomic) stability. Tax provides macroeconomic stability by being used as a fiscal lever in times where there is too much demand & not enough supply of certain goods or services in the economy. This situation can increase inflation, defined as the general price of goods & services as measured by the Consumer Price Index (CPI). Imposing a tax on the scarce goods or services can reduce demand, & therefore reduce inflation.
Sustainability
Finally, tax is a more sustainable source of finance for southern governments for a few reasons. Firstly, it is less likely to be vulnerable to the sudden removal of money or capital from a country, so called ‘sudden stops’.
Secondly, tax from revenue isn’t subject to interest repayments, unlike debt. Financing projects via debt can result in the tax raised domestically going towards paying off the debt, reducing the revenue available for public services. Debt servicing can thus swallow tax revenue. For example, in Nicaragua in 2008, debt servicing swallowed one quarter of the entire annual tax take, which was equivalent to 36% of total public spending & was more than the country’s entire health budget that year. Another example can be found in the Philippines where the debt service from 1986 to 2008 for interest payments averaged just over 25% of the country’s national budget. This was without paying off any of the principal of the loan; it was solely paying the interest. More recently in 2010, just under 25% (24.34%) of the Philippines’ budget was spent on interest repayments & just under 30% (28.95%) went towards paying off the principal. In contrast, 28.5% total was allocated to public services like health, education & housing.
The third reason that tax may be preferable to debt as a financing tool is that with loans, external donors (that don’t necessarily understand the needs of the country) can dictate how the loan is spent, rather than the domestic government. Increasing the domestic tax take reduces a country’s reliance on external loans & the debilitating repayment of these loans into the future, & affords them increased agency & space to determine their own national policies (fiscal sovereignty) rather than having them dictated by donors.
What about aid?
There is a role for foreign aid, however there are a number of issues attached to relying on aid rather than tax revenue as a source of national finance. Firstly, aid can encourage rent-seeking behaviour in the political elites in the country receiving aid, an economic concept referring to when an entity seeks to gain wealth without any reciprocal contribution of productivity. Secondly, it can make rulers accountable to foreign donors rather than their populace, increasing government responsibility to donors, while sacrificing their ability to be genuinely responsive to their citizens. Thirdly, aid is volatile, as its amounts can change rapidly over a short period of time. This reduces the ability of the government in the aid-receiving country to plan accordingly into the future. Finally, aid is unable to match the revenue-generating potential of tax. In fact, some have estimated the revenue loss of corporate taxes of low-income states due to to be greater than the combined foreign aid budgets of high-income states in 2007. “We calculate…that the loss of corporate taxes to the developing world is currently running at US$160bn a year (£80bn). That is more than one-and-a-half times the combined aid budgets of the whole rich world – US$103.7bn in 2007.” (p. 2)
A note on Modern Monetary Theory
Another part of the story of tax has to do with Modern Monetary Theory (MMT). From the perspective of MMT theorists, spending and taxing in a country’s own currency creates a cycle that allows money to be created, and so gives worth to currency. Money is spent into the economy and then taxed; i.e. revenue is not always required to be sent to the government before it can be spent. This is a little challenging to get one’s head around as it is fundamentally different to the way most people are taught to think about the economy! Please see the FreshUp article on Modern Monetary Theory for more information on this concept and how it relates to tax. It’s also important to note that many countries around the world cannot issue their own currencies. What’s more, in order to trade on international markets, dollars must be used as it is to the dollar that all other currencies are pegged.
