‘Good tax’ has basic principles

A good tax? Can there be such a thing? Many factors contribute to why Maine residents find themselves living in a state with high per capita taxes. The overall burden is one issue. But it’s a separate issue to consider how the general tax burden – whether heavy or light – is distributed among us all.

We tax income, consumption and wealth. In fact, each level of government has tax categories it favors and others it traditionally stays away from. Federal and state-level governments favor income taxes on personal incomes and business profits. Income taxes also encompass a family of taxes known as payroll taxes that help fund Social Security and unemployment compensation programs.

States are the biggest users of consumption taxes. These include retail sales taxes, special taxes on commodities such as petroleum products, and “sin” taxes such as those on alcoholic beverages and tobacco. The federal government has traditionally stayed away from retail sales taxes, though it taxes tobacco, alcohol, gasoline and other such products. Some states permit an add-on of 1 percent or so to the state sales tax rate, then return that percentage to the locality where it was collected. (Maine is not one of those states.)

Localities are the heaviest users of taxes on wealth, although both federal and state governments assert wealth taxes in limited ways. The most prevalent tax on wealth is the property tax on real estate, but this tax category also includes taxes imposed on personal property, on estates left by decedents and on large gifts.

Finding an equitable mix of these taxes is not easy. There is no single solution. Each possibility affects some people differently than others – which is where reasonableness, creativity, political will and public pressure become essential.

Each of the three basic categories of taxation – taxes on income, consumption and wealth – has its strengths and weaknesses. That means there is no “best” tax, though we sometimes argue as if there were. Nonetheless, such arguments can be healthy public discourse when they are based on commonly accepted principles, characteristics or criteria for evaluating what makes a tax bad or good. And it turns out that such criteria do exist: Five interrelated principles for creating a good tax are fairness, simplicity, neutrality, administrability and sufficiency.

A fair tax is one that has approximately the same relative impact on all taxpayers. One facet of a fair tax is that it has “horizontal equity,” which simply means that taxpayers in similar situations pay the same amount of tax. Horizontal equity is tougher to achieve than it seems; consequently, a large part of any tax code is devoted to getting to that bottom line.

A second facet of a fair tax is “vertical equity,” which means being mindful that taxpayers of lesser means will be harder hit by a given tax percentage than will taxpayers of greater means. Proportional and regressive taxes hurt poorer taxpayers the most, while progressive tax rates dampen that impact.

Progressive taxes, such as our federal and state individual income tax rates, are graduated so that high-income taxpayers pay higher tax rates than do low-income taxpayers. But many taxes tend to be regressive, disproportionately hitting taxpayers at the lower end of the economic spectrum. This is true for payroll taxes, which stop after the worker earns a certain amount of salary during the year. Property and sales taxes also tend to be regressive unless they are tempered in ways that mitigate their impact on low-income taxpayers.

Of course, “tempering” has a way of reducing a tax’s simplicity, the second characteristic of a good tax. A simple tax is one that is easy to understand and comply with. A straight retail sales tax is probably the simplest tax around; but, in its pure state, it is also one of the most regressive. So, unfortunately, fairness and simplicity are often at odds when designing a good tax.

Neutrality is the third principle. A neutral tax is one that does not influence whether parties will prefer one type of exchange over another. (This isn’t the same as a similar-sounding tax term, “revenue neutral,” which means a new mixture of taxes calculated to yield the same overall tax revenue.)

The fourth principle is to establish an administrable tax, a tax that is workable to implement and maintain. If our government can’t enforce a tax effectively, establishing that tax is probably a bad idea. Simpler taxes are typically easier to administer than are complicated taxes. Collection at source (as with a retail sales tax or with income tax withholding on wages), for example, is more effective than after-the-fact compliance.

The fifth principle, a sufficient tax, is one that raises sufficient revenue to address the need for which it is imposed. The broader the base over which a tax is spread, the more revenue-generating potential that tax has. But determining the appropriate base raises potential conflicts among the principles of fairness, simplicity and sufficiency – if not among all five principles.

In the real world, consequently, coming up with a “good tax” is tough.

The good news is that, although these principles generally apply to a specific type of tax, they readily apply to a mixture (hopefully, an orchestrated mixture) of taxes designed to offset the structural weaknesses of one type of tax with the strengths of another. Striking that balance is difficult given the needs of the many stakeholders. Even so, taxes are what we pay for civilized society, as Supreme Court Justice Oliver Wendell Holmes reminded us long ago. Finding ways of optimizing each of these five principles is an essential battle in determining what, for all Mainers, will be “a good tax.”

Ken Nichols is an associate professor of public administration at the University of Maine and a former administrator with the Internal Revenue Service. His e-mail address is kenneth.nichols@umit.maine.edu