Fundamentals of Taxation: Chapter 2 - Principles of Taxation (IBFD 2019) PDF

Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) Chapter 2: Principles of Taxation Editors: Pasquale Pistone Jennifer Roeleveld Johann Hattingh João Félix Pinto Nogueira Craig West https://doi.org/10.59403/dkegen 2.1. Features of a good tax policy 2.1.1. Introduction Chapter 1 discussed (i) the broader ﬁscal policy consideration; (ii) the need to achieve a budgetary balance when drafting a sound ﬁscal policy; (iii) the justiﬁcation for raising taxation; and (iv) the purposes for which taxes are levied. It was clear from that chapter that a holistic picture is necessary to establish a full ﬁscal policy, but such ﬁscal policy design and the quantum of tax to be raised to meet the needs of any particular government is beyond the scope of this book. In the design and development of tax policy (i.e. only the revenue-raising side of ﬁscal policy), there are certain universal factors that should be present in order to levy taxes and achieve eﬃcient collection of taxes (irrespective of the quantum desired or the speciﬁc goals to be achieved). This chapter discusses these universal factors that should be present in any well-designed tax system. These factors are often referred to as the “building blocks” of tax policy. While the starting point for the building blocks of tax policy are usually drawn from Adam Smith’s 1776 work, “An Inquiry into the Nature and Causes of the Wealth of Nations”, these initial building blocks have been subdivided and expanded into a more modern list in line with the changes in the economy and globalization. Despite this development, there are still overarching themes into which these building blocks may be classiﬁed. These are (i) equity within the tax system; (ii) economic eﬃciency of the tax system; (iii) administrability of the tax system; and, more recently, (iv) coherence of the tax system (both domestically and globally). Under these broad categories, the building blocks are identiﬁed, deﬁned and discussed in sections 2.1.2.1.-2.1.5.5. In its simplest form, tax policy attempts to achieve “fairness” of taxation shaped by a variety of external inﬂuences and factors. 2.1.2. Equity 2.1.2.1. Deﬁning equity in tax policy The traditional thinking with respect to equity within a tax system hinges on the “beneﬁt principle” and the “ability to pay” principle. Both of these concepts are further intertwined with other concepts. In its most simple form, “equity” is about “fairness” in the taxation system. This is a ﬂuid concept that depends on many other non-tax factors, such as culture, political inﬂuence and the importance of redistribution. The beneﬁt principle proposes that all persons contribute (pay taxes) in accordance with the beneﬁts that they receive from government goods and services. The diﬃculty in this regard is the measurement of the “beneﬁts” received. Numerous functions provided by a state serve all people of the state, irrespective of whether they contribute or not. The principle is therefore interpreted on the basis that persons contribute in accordance with their ability to pay in order that all may receive access to the collective beneﬁts oﬀered by the state. This ability-to-pay concept may be deﬁned as follows: [A] principle of tax economics, based on the theory that taxes should be equitable, that a taxpayer’s burden should reﬂect his economic capacity to bear that burden relative to other taxpayers. Income is traditionally considered to be the best measure of a person’s ability to pay. However, alternative measures of economic position, such as consumption and net worth, may also be used for these purposes. The principle is used, inter alia, as an argument for progressive tax rates, for the imposition of taxes on capital and for various allowances such as age and disability allowances. Although it may appear inconsistent with the beneﬁt principle, the two may arguably be reconciled. (IBFD Glossary) However, this concept is frequently criticized with regard to the period for which this ability to pay should be measured. In its purest form, the ability to pay should be measured over the lifetime of a taxpayer, but this is clearly impractical from an administrability Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 1 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) perspective. The application of the concept to tax policy therefore usually refers to a deﬁned tax period. The ability to pay should also be considered with reference to two key elements, namely horizontal and vertical equity. 2.1.2.2. Horizontal equity Horizontal equity may be deﬁned as “[a] variant of the principle of individual equity that holds that similarly situated taxpayers should receive similar tax treatment, e.g. taxpayers who earn the same amount of income or capital should be taxed in the same way” (IBFD Glossary). Horizontal equity is easily understood when comparing similar forms of income. For example, two individuals earning the same salary should bear the same taxation. Greater complexity arises when diﬀerent forms of income or capital appreciation need to be considered. Economic income considers unrealized capital appreciation to be the same as income from a cash salary. Furthermore, passive income earned should also be taxed in the same manner as a cash salary in order to achieve horizontal equity. In tax design, passive income streams are often subject to relief that is not aﬀorded to earnings from labour, and thus, horizontal equity is not achieved. This form of equity is considered intuitive and, for the most part, observable. As a visible form of fairness, failure to achieve horizontal equity can drive non-compliance levels higher. The diﬃculty with the concept of equity is that tax systems provide visible evidence of equity on an annual basis, whereas true equity may only be ultimately achieved when considering the economic income of a person over their lifetime rather than a single period. Perceived inequity may in fact be resolved through later taxation (such as taxes only levied on realization or estate taxes) or through the correct measurement of the “economic incidence” of taxation. The “incidence” of taxation refers to the amount of tax that an individual ultimately has to bear. An example is corporate taxation levied on a ﬁctional entity. Regarding the economic incidence of tax, the tax burden ultimately falls on a number of persons, e.g. capital owners, employees and customers. 2.1.2.3. Vertical equity Vertical equity, in contrast to horizontal equity, may be deﬁned as follows: A variant of the principle of individual equity, which holds that diﬀerently situated taxpayers should be treated diﬀerently, e.g. taxpayers with more income and/or capital should pay more tax. This results in the proposition that “appropriate” diﬀerences should be made between the tax treatment of taxpayers in diﬀerent economic circumstances. The principle lies behind the imposition of tax at progressive rates. (IBFD Glossary) Vertical equity directly considers whether taxes are regressive, proportional or progressive. Generally, regressive taxes are to be avoided, as these place a greater burden on low and middle-income families in that a greater proportion of their income is taxed. However, regressive taxes should not be immediately disregarded, but should rather be considered within the mix of taxes in the state to determine the overall regressivity or progressivity of the taxes. Examples of regressive taxes include property taxes, excise taxes and value-added/sales taxes. Proportional (or ﬂat) taxes, at ﬁrst glance, would appear to be the most equitable form of taxation because for every additional monetary unit earned, the same proportion of that additional unit is taxed. However, the application of a proportional tax depends entirely on the tax base on which the tax is levied. The tax base may render the tax either regressive or progressive. Progressive taxes (such as income tax) entail increased rates of tax for higher levels of income, shifting the tax burden onto the higher income earners as a means of redistribution of wealth. All states tend to use a mix of regressive and progressive taxes. However, the level of income from each of the taxes must be considered. If regressive taxes form the bulk of tax revenue, the overall system may well be regressive, and there is a limit to how much the regressive nature can be overcome by progressive taxes, such as income tax. Being overly reliant on a single form of progressive tax in order to overcome regressive taxes may lead to non-compliant behaviour of upper income earners. It would be better for a state to attempt to minimize the regressive nature of such taxes while balancing the remaining regressive nature with progressive taxes. Various techniques may be used to reduce the extent to which a tax is regressive, such as rebates, exemptions or other forms of shields against tax for lower income households, tax credits and other forms of relief. Generally, subsistence income and goods should be free of taxation, relieving any pressure on the poor. Another mechanism to achieve equity is that of transfers (such as social grants). Funded from taxes levied on the tax bases, such transfers represent a redistribution of wealth from the rich to the poor. Of course, the existence of transfers in the system suggests a suﬃcient revenue base to accommodate government expenditure and such transfers. However, excluding transfers from the analysis of equity would provide an incomplete understanding of equity for the purpose of taxation. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 2 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) 2.1.2.4. Legitimacy Key to a tax system is the actual and perceived legitimacy of the levying of a tax. While states are free to legislate any tax, taxes with no nexus to that state will be generally unenforceable and possibly inequitable. 2.1.2.5. Inter-nation equity Flowing from the consideration of these concepts from the perspective of equity among taxpayers, inter-nation equity concerns the division of taxing rights between states. To some extent, less attention has been given to the issue of inter-nation equity, particularly regarding the concept of vertical equity between states for the purpose of encouraging progressivity in the division of taxing rights between developed and developing states. Of course, the division of taxing rights must be accompanied by some nexus to the state claiming a taxing right. Equally, issues of tax competition between states can result in inequalities, including, for example, the so-called “race to the bottom” as regards corporate tax rates. However, in other instances, they may well be justiﬁed based on the economic position of the particular state. Regularly, regional bodies mandate that their member states may not engage in tax competition that would be harmful to other member states. 2.1.3. Economic eﬃciency 2.1.3.1. Deﬁning economic eﬃciency for tax policy Economic eﬃciency in a tax system concerns the concepts of neutrality of the tax system, the stability of the tax system, the simplicity of the tax system, the appropriate use of resources (productivity) and the suﬃciency of the taxes collected to fund the state’s activities. Essentially, “eﬃciency” refers to the cost to society that taxation brings through its impact on and possible distortion of economic behaviours and the attempt to minimize these impacts and distortions while achieving the societal goals of the particular state. 2.1.3.2. Neutrality Tax neutrality means that tax should create no advantage or disadvantage with regard to any transaction or investment. This concept of neutrality extends to both inward-looking (capital import neutrality, implying that investments are subject to the same level of taxes irrespective of whether the investor is a resident) and outward-looking (capital export neutrality, implying that investments made within or outside the country are subject to the same taxes for residents) perspectives. Neutrality further has a direct link to the concept of equity discussed in section 2.1.2. in that the avoidance of distortions prevents a shift from highly taxed activities to activities taxed at lower levels. Eﬃciency requires that a tax policy ensures the minimization of any distortions that tax may introduce into the economy through inﬂuencing the productive use of resources in the country. Tax incentives are a natural example of distortive aspects of a tax system. Incentives send market signals to the targeted sector, resulting in a potentially ineﬃcient allocation of resources and impacting productivity (see section 2.1.3.5.). To achieve neutrality, such elements of tax design should be minimized or eliminated. 2.1.3.3. Stability Stability in the tax system generates certainty for taxpayers and prevents unnecessary increases in compliance costs. Should the tax system be regularly changed (not referring to minor annual changes to the tax law, but to larger changes), the lack of stability can create adverse consequences for commercial transactions and investments. 2.1.3.4. Simplicity Simplicity in the tax system works with stability and neutrality. Complexity in tax systems usually incites avoidance behaviour, as the more complex the system is, the greater the likelihood of inequalities in the taxation of income, leading to distortionary eﬀects and higher compliance costs. However, both simplicity and neutrality are often necessarily surrendered. There is a natural complexity to tax systems, as the various taxes interface, have diﬀerent bases, applicable rates and rules and have a range of anti-avoidance measures. While multiple taxes certainly introduce complexity, they also add to stability (see section 2.1.3.3.) by preventing over-reliance on one tax. An example would be when a state generates suﬃcient tax revenue from rent on a simple resource over that on a natural resource. When that resource is suddenly no longer attractive to the market or is exhausted, the simple tax system has no mechanism to quickly shift the revenue generation to other existing taxes. Complexity in a tax system adds to both the cost of compliance and the administrability of the tax system. Complexity can directly impact economic eﬃciency (see section 2.1.3.) and enforceability (see section 2.1.4.5.). Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 3 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) Simplicity can also be viewed in two contexts, namely (i) simplicity in the taxes applied (e.g. legal certainty in tax law); and (ii) simplicity in the compliance with the law (e.g. pre-populated tax returns, transparency and a free ﬂow of information between the tax authorities and other governmental bodies). The latter is discussed in section 2.1.4. 2.1.3.5. Productivity Economic eﬃciency should also be considered in light of the view that tax is ultimately a cost to productivity. Taxes create real costs, known as “deadweight costs”, for the economy (i.e. the reduction in supply as costs increase, caused by the increased price that the tax introduces). Of course, deadweight losses can be minimized. When demand is inelastic, higher tax rates can be levied on the relevant goods, as the demand will not ﬂuctuate, despite the higher rate of tax. Conversely, when demand is highly elastic, the tax rates should be lower in order to minimize deadweight loss. Such minimization of deadweight loss can naturally conﬂict with the concept of equity when, in a developing economy with inequality of wealth, the goods with inelastic demand are goods consumed by both low-income and high-income persons. High tax rates on goods with such inelastic demand place an undue burden on low-income persons and reﬂect regressivity. While it is important for each citizen to productively contribute taxes, in unequal societies, the concept of equity may play a more signiﬁcant role than in suﬃciently developed economies. This is illustrated in ﬁgure 2.1, with the middle triangle representing the deadweight loss. Figure 2.1 Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 4 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) This diagrammatic representation further illustrates a key consideration of eﬃciency, namely government intervention to adjust market reaction. Taxes are often used to alter behaviour either by encouraging certain activities, such as investment (through the use of incentive schemes), or discouraging others, such as the use of tobacco and alcohol (through the use of high excise duties). Taxes have a naturally distortive eﬀect, but some are intentionally distortive (often called “Pigouvian taxes”). Pigouvian taxes are intentionally distortive in order to stimulate a particular behaviour. For example, taxes on carbon emissions are intended to discourage performing activities that produce such emissions. Such taxes are not designed to generate revenue and should, in theory, have a limited lifespan. That is to say, if they are fully successful, no further revenue will be generated by the tax (as the behavioural change will be fulﬁlled). Further costs directly impacting productivity include both administrative costs (the cost to actually collect the tax and run the revenue authority) and compliance costs (costs incurred by the taxpayer to comply with the tax law). For more on this, see also section 2.1.4. The costs related to taxation and the decision-making eﬀect that taxes have can lead to eﬀects known as the “income eﬀect” and the “substitution eﬀect”. The income eﬀect refers to the direct impact that taxes have on reducing the purchasing power of the income earner. This not only has the impact of reducing the amount that the income earner can spend in the market, but also reﬂects a transfer of the budget from the private sector to the public sector. When such transfer of the budget is done eﬀectively, economic eﬃciency is not necessarily reduced. The substitution eﬀect refers to the decision to alter working hours, levels of education, retirement age and other opportunity costs of work based on the taxation levied on such activities. Similarly, the substitution eﬀect, through its eﬀect on the price of goods, may directly impact the consumption behaviour of taxpayers. Linked to productivity, simplicity and stability is the recognition that taxes should contribute to eﬃciency in the allocation of economic resources and the stabilization of economic cycles and should contribute to the economic development of the state and its participants. 2.1.3.6. Suﬃciency Economic eﬃciency in a tax system also implies that a state should extract no more tax than is necessary to fund (eﬃciently and appropriately) government expenditure. Suﬃciency of tax revenue also suggests that, in an ideal environment, governments should be able to raise suﬃcient revenue from taxes and not have to resort to borrowing in order to fund government expenditure. Borrowing naturally results in a future tax burden to fund the interest and capital on such borrowings, reducing the tax contribution directly to the then-government expenditure needs. The justiﬁcation for government borrowing to fund current expenditure is also weak in light of the principle of “no taxation without representation” for those persons tasked with funding such borrowings with their future taxes. 2.1.4. Administrability 2.1.4.1. Deﬁning the administrability of tax policy Key to any tax system is the administrability of that system. The concepts within administrability equally speak to the concepts of equity and eﬃciency (naturally so, as none of these concepts can or should be considered in isolation). In simple terms, the cost of collection of a tax should not be excessive. States are responsible to use the resources entrusted to them eﬃciently, including in the collection of taxes. The inability to monitor and enforce taxes imposed by a state renders them ineﬃcient, creating discontent between eﬃciency and equity. Numerous concepts are grouped within administrability but have elements of other building blocks. 2.1.4.2. Certainty, transparency, accountability and legality Certainty in tax matters may be described as requiring that the “taxpayer should know exactly what is being taxed, how much he has to pay and how and when he has to pay it, meaning that the law should be clear and unambiguous and the tax authorities’ interpretation of it should be readily available” (IBFD Glossary). Visible, transparent taxes allow taxpayers to evaluate the services received and the accountability of the government relative to the tax burden faced. Transparency with respect to taxes also facilitates a clear demonstration of the redistributive elements of the tax burden. Publications showing the data as to the incidence of taxation (that is, on whom the ultimate tax burden falls; for example, corporate taxes are ultimately borne by individuals in the form of wage taxes, higher prices, etc.) all facilitate greater transparency and accountability. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 5 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) Certainty should also be present in the manner in which returns are to be completed and ﬁled. Certainty for the taxpayer that he can comply with the tax law encourages good compliance behaviour. There should equally be certainty in the manner in which the tax law will be interpreted and applied (especially by the tax authorities). Providing too much discretionary power to the tax authorities will decrease certainty. Equally, there should be transparency in respect of the manner in which the tax authorities apply the law, which should be uniform for all taxpayers. The concept of law versus discretion is discussed further in section 2.3.7. Certainty further ensures that the clarity of tax laws facilitates the taxpayers’ understanding of when and how tax liability arises, as well as certainty regarding the extent of the liability. Coupled with the concept of certainty is the principle of legality, which is “[a] fundamental principle that requires the law to be clear, ascertainable and non-retrospective. The principle may be applied in a tax context, for example, to require that the rules imposing or providing relief from taxes be published in legislation” (IBFD Glossary). Legality is further discussed in section 2.3.6. 2.1.4.3. Collection cost/tax yield The administrability of a tax should take into account the cost (to the government) to collect the tax versus the tax that will be achieved through the appropriate enforcement. When the type of tax to be administered would be expensive to administer, i.e. the cost to collect the tax would outweigh the tax collected (the tax yield), the value of the inclusion of such a tax in the tax system must be questioned. The eﬃciency and convenience of the tax collection and enforcement mechanisms should also be evaluated. Tax authorities should constantly review collection practices in an eﬀort to improve eﬃciency and reduce the cost of collection. In a good tax system, taxes with broad bases and simple, cost-eﬀective administration are preferred. However, the cost to the state of the collection of taxes should also not simply be transferred to the taxpayer or third parties. High administration costs or withholding collection costs incurred by third parties (for example, banks, medical schemes or insurance companies) on behalf of revenue authorities all serve to make these institutions less eﬃcient (i.e. redirect productive resources to unproductive functions not associated with the third party’s core business) and erode the concept of economic eﬃciency in a tax system. 2.1.4.4. Simplicity Unlike simplicity as discussed in section 2.1.3.4., simplicity in the context of administrability refers to the facilitation of taxpayer compliance. Simplicity with regard to compliance represents an eﬀort to guard against the rising cost of compliance and enforcement that complex legislation brings. Overly complex provisions raise compliance costs and increase the deadweight loss caused by taxes in general (see section 2.1.3.5.). It suﬃces to say here that simplicity also provides a sense of equity for the taxpayer in that simplicity of compliance provides greater visible equality. Complex tax rules render the system diﬃcult to understand, and equally diﬃcult for revenue authorities to enforce. Complexity frequently leads to aggressive tax planning and abusive practices, taking advantage of loopholes inadvertently created. Complexity also leads to inequality, as those that can aﬀord the necessary tax advice may reduce their burden, putting those that cannot at a disadvantage. Collection mechanisms, such as pay-as-you-earn and the levying of VAT on the acquisition of goods and services, are examples of administrative measures seeking to ease the compliance burden on the persons liable to tax. In the former case, the liability to income tax on the salary rests with the employee, but the relevant tax is withheld and paid to the tax authorities by the employer. In the latter case, VAT is incurred by the consumer, but collected and paid to the revenue authority by the supplier. Such collection mechanisms serve to make the payment of tax convenient for the person liable to tax. Further simpliﬁcation can be achieved through pre-populated tax returns based on information received by the tax authorities from third parties. Ease of ﬁling can greatly enhance taxpayer compliance. Simplicity for the sake of taxpayer compliance adds a level of protection for taxpayers against exploitation by both the tax authorities and unscrupulous tax advisers. 2.1.4.5. Enforceability A distinction should be made between the enforceability (and therefore, the administrability) of taxes in a developed versus developing economy. In formal markets, which are established and well regulated, regulation and enforcement are generally simpler to ensure. In states with large informal economies, compliance and enforcement mechanisms do not guarantee the payment or collection of taxes. Any tax design must take into account the practical enforceability of the tax to be levied. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 6 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) Enforceability should take into account the simplicity of operating the tax system from both government and taxpayer perspectives. Simple systems requiring low compliance costs may serve to signiﬁcantly reduce the tax gap (the diﬀerence between the tax that should be collected and the tax actually collected). Frequently, in developing economies, a means of enforcement consists of excessive sanctions for avoidance behaviour of taxpayers. Such enforcement action may cause the underlying economic activity taking place in that state to cease altogether and therefore deprive the state of any future (legitimate) tax claims. Excessive taxes themselves may also be the cause of evasion, abusive practices, aggressive tax planning or black-market activities. While sanctions do form a part of any good tax design, the sanctions must be proportional to the oﬀence; the tax should not be excessive from the start. For more on sanctions, see chapter 6. 2.1.4.6. Information security and conﬁdentiality Vital to the design of any tax system and the administration of that system are safeguards and the protection of taxpayer data. Erosion of the standards of conﬁdentiality will lead to non-compliant and evasive taxpayer behaviour. The incorruptibility and impartiality of the tax authority is paramount to the success of information security and conﬁdentiality. 2.1.5. Coherence 2.1.5.1. Deﬁning coherence In deﬁning coherence for the purposes of this book, it should be understood as incorporating elements such as the stability of the tax system, the manner in which tax reform is managed, the interaction of taxes within the system, consideration of the interaction of taxes between diﬀerent tiers of government and the interaction of the system with international tax developments. 2.1.5.2. Interaction within and between taxes Firstly, and naturally, any tax system will have to take account of the speciﬁc realities and activities within the particular economy. Broad issues of coherence include consistency of the tax law with the legal system and drafting style of the speciﬁc country. Further, any tax system should aim to avoid instances of economic double taxation (i.e. taxing the same revenue/income twice) within a tax. For example, the tax system should be coherent as regards deductions and income. For instance, a deduction should only be granted when it will provide for a taxable receipt in the hands of another. As another example, by not permitting retirement contribution deductions, the tax system designed should exempt retirement beneﬁts received. This demonstrates the need for the tax system designer to be cognisant of the longer-term impacts of any choice made regarding the tax design. Secondly, domestic coherence considers the interaction of the various taxes levied by the state (and is linked in part to equity) in order to ensure that the overall tax burden is not skewed towards one particular group of taxpayers (progressivity of a particular tax aside) and create economic double taxation across the system. Adjusting a tax system must take into account all elements of the tax system. For example, a certain exemption from income taxation may be justiﬁed by the consumption taxation of a good. Simply abolishing the exemption without taking into account the consumption tax may lead to skewing the tax system as a whole. This is an often overlooked aspect of tax reform. Thirdly, coherence of the tax system is needed in order to ensure that tax revenue (also in relation to state borrowings) is suﬃcient to cover both current operational and capital expenditure by the state. To the extent that the state continues to borrow in order to cover current expenditures, this places an ever-increasing burden on future taxpayers (see also section 2.1.3.6.). Finally, with reference to federal systems, a coherent tax system should ensure that federal and lower tiers of taxation are complementary rather than competitive (for example, when income taxes are levied at the state level, but consumption taxes at federal level). 2.1.5.3. Broad base The base on which a tax may be levied should also be considered when designing a tax system. Generally, the broader the tax base (that is, the more taxable persons covered by the tax), the greater the stability of the tax and the perceived “fairness”, because everyone contributes. A broad base also serves to minimize individual tax burdens. 2.1.5.4. Tax mix Most states have adopted three to four taxes with large yields, namely income taxes, consumption taxes, property taxes and inheritance or estate taxes. This has not prevented a multitude of other taxes from being introduced for a number of policy and social reasons, such as environmental taxes, excise duties on various products, industry protection tariﬀs, fuel levies and wealth taxes etc. Some of these other taxes tend to be designed for ease of collection (at the point of purchase) in order to lower the administrative costs and increase the yield. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 7 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) The fundamental consideration in designing a tax system in order to gain coherence is the use of diﬀerent taxes to achieve diﬀerent aims. The mix of taxes also adds to the stability of the economy during times of varying economic conditions. Further, in utilizing a mix of taxes, especially that of direct and/or indirect taxes, it is more likely that a balanced system is achieved when the various tax bases provide an equitable share for all (see section 2.1.2.). Single taxes run the risk of there being too great a focus on a single activity or revenue stream that, if disrupted, can undermine the entire tax system. The canon of diversity speaks largely to the tax mix of any state. Naturally, over-reliance on any one tax can create signiﬁcant revenue risks for that state should any underlying factors be destroyed. This has previously been observable in states over-reliant on natural resource levies when the state did not diversify with other forms of tax revenue, such as personal income tax or consumption tax. It is for this reason that most states utilize personal income taxes, corporate taxes and consumption taxes as the diverse base. With economic downturns generally heavily impacting corporate taxes, personal taxes tend to remain fairly stable as a result of ongoing employment. Similarly, consumption taxes tend to be stable with regard to most necessary items with a decrease in the consumption of some luxury items. The design of the exact mix of taxes will vary from country to country and depend on the speciﬁc circumstances and possible tax bases. 2.1.5.5. Adaptability and continuity A coherent tax system must also be ﬂexible (elastic). This means that the tax burden can be increased or decreased in line with the demand for tax revenue in response to economic eﬀects within the state. Selecting taxes that are inelastic renders the tax system unresponsive to changes in government objectives or global economic impacts. Elasticity is often found in direct taxes, such as personal income tax. These are also progressive taxes and are used for redistributive purposes. Heavy reliance on corporate taxation or natural resource taxation can often lead to the tax system being conﬁned to cyclical revenue ﬂows, and hence is inelastic. Tax systems need to be ﬂexible enough to adapt to the increasing pace of global and technological developments. This is true for developed and developing economies, although some developing economies remain necessarily focused on building a strong domestic tax system and capacity for administration. 2.1.5.6. International coherence The international perspective adds a further dimension to the consideration of coherence. Clearly, domestic tax systems interact with one another in global markets. This necessitates forms of coherence (or cooperation). Coherence in this context may equally refer to situations in which the diﬀerent treatment of non-residents versus residents may have to be justiﬁed. 2.1.6. Challenges in application 2.1.6.1. Tax mix to be relevant While all the features of good tax policy should be present for any tax, it is clear that they must be balanced with an optimal mix depending on the ﬁscal policy and economic needs of the particular state. In essence, these features, as discussed above, represent an ideal rather than reality. For example, an administratively convenient tax may be inequitable, and an equitable tax may be burdensome to administer. These elements must take into account the needs of the state and sacriﬁce (at least partially) the relatively less important element for the sake of the more important/relevant element. 2.1.6.2. Understanding the purpose of the tax Key to the understanding of a tax design is that diﬀerent taxes may serve diﬀerent purposes. Apart from general taxes, the purpose of which is simply to raise suﬃcient revenue to ﬁnance government (eﬃcient) expenditure and which is governed by the broad principle of the ability to pay, some taxes are introduced with a speciﬁc purpose or to generate a speciﬁc response. While most taxes should interfere as little as possible with the economy, others seek to inﬂuence behaviour. Often, tax is a very blunt instrument with which the behaviour of taxpayers may be changed. Care must be taken that taxes do not generate unintended consequences and should be designed to facilitate a feedback mechanism to evaluate the success of the tax where a behavioural policy has been applied. In many cases, the tax aims to be a deterrent to a particular behaviour. Consider taxes on plastic bags, sugary drinks, fat content in products or “sin” taxes on alcohol and tobacco. Other taxes may serve a regulatory purpose, for example, regulating access to goods or services. In other cases, taxes may be used in a speciﬁc economic context (e.g. ﬁghting inﬂation by decreasing the amount of available purchasing power) in order to boost speciﬁc economic sectors or activities. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 8 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) 2.1.6.3. Developing versus developed countries Economic research has shown that prosperous countries (generally developed countries) have higher tax-to-GDP ratios. This is generally achievable due to the broad tax base and lower levels of societal inequality. In developing countries, tax-to-GDP ratios are much lower. High societal inequality further results in even progressive taxes being levied on few and regressive taxes being (politically) unfavourable due to the impact on low-income earners. It is in such circumstances that the tax design becomes crucial. Over-taxing high net-worth individuals can lead to either tax emigration or tax evasion and avoidance, and the over-use of regressive taxes can lead to low levels of general tax compliance. Such circumstances make it diﬃcult for developing economies’ governments to raise suﬃcient revenues to meet government expenditures. This leads such governments to borrow funds (issue government bonds or seek foreign aid) to cover the expenditures that tax revenue cannot. Borrowings in turn place an increased burden on the same government to fund the interest (and ultimately capital) repayments. Lack of administrative capacity in developing countries plays a further key role in the inability of the developing country to collect taxes and develop domestic solutions and respond to global challenges. Global solutions may not always suit the domestic circumstances of the developing country. Extensive investment in capacity building is generally required, along with stimulating the economy and broadening the tax base. 2.1.6.4. Reliance on external reference points In an increasingly global economy, not only do tax systems need to cater to the unique circumstances of the state, but the basis on which taxable income is to be determined for income tax is becoming increasingly harmonized. In this regard, a trend can be observed among income tax systems (particularly for corporate taxation), as they are becoming more reliant on accounting standards (namely the International Financial Reporting Standards) to set a common base. From this common base, deviations commonly occur in order to ﬁnalize the taxable amount and take any country-speciﬁc factors into account. Many tax systems rely, to some extent, on accounting standards. However, two alternative extremes may occur, i.e. either (i) total dependence on the accounting proﬁt determination for tax purposes; or (ii) complete independence from such external standards. Such reliance clearly has pros and cons. Reliance on any external standard should be analysed in light of the particular country’s circumstances. 2.2. Economics and tax policy Taxes are a feature of modern governments. Clearly, the tax system should be an eﬃcient one, and further, the expenditure of the government should be limited to that which is absolutely necessary. Economic theory demonstrates that taxes clearly draw resources from both eﬃcient and productive use in the private sector (which is ensured through market forces) and less eﬃcient use in the public sector. As governments are not subject to the same market forces to compel the eﬃcient use of resources, the consequence of the failure of policies towards which government expenditure was put are not severe, often allowing the wasteful behaviour to be perpetuated. Productivity of the economy suﬀers as a result. The greater the ineﬃcient use of resources, the more economic growth suﬀers. At various points in history, this has been demonstrated when, in a downturn, governments have raised taxes and maintained expenditure, leading to a longer recovery. This can be contrasted with situations in which governments have decreased expenditure in a downturn and decreased tax rates, leading to a swifter economic recovery. This does not mean that taxes should not be levied, but reminds the designer that taxes should not be excessive, nor should the use to which the taxes are put be wasteful. A broadening and diversiﬁcation of taxes across various bases can lower the overall burden on taxpayers. Even when the tax base is narrow, a tipping point will be reached when the marginal return from an increase in the tax rate slows and after the tipping point decreases. At the point of decrease, compliant taxpayer behaviour is eroded and tax evasion rises. As can be seen from the principles above, tax policy and the economy are inextricably linked. States are tasked with developing broad policies that look towards the future with regard to issues such as economic growth, distributive eﬀects, infrastructure, state-owned entities, incentives for the private sector and global issues, to name a few. Once the governmental policies have been set, the tax policy serves to ensure that suﬃcient revenue will be collected to serve such policies or directs the revenue to the prioritized policies. In this respect, it should be remembered that tax should inﬂuence the economy as little as possible (i.e. not distort economic activity). The attempt to avoid tax distorting the economy is known as the neutrality principle. Distortions in economic activity increase the deadweight loss caused by the impact of tax on market prices. Favouring one sector over another as a policy objective can also lead to the misallocation of resources, introduce discriminatory practices and inﬂuence the investment or spending decisions of individuals (causing decisions to be made as a result of the tax law rather than the economic impact). Resources are generally better utilized when economic activity is left to the open market. However, governments do get involved in global issues directly inﬂuencing the market with regard to environmental and health issues (such as sin taxes on alcohol and tobacco). Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 9 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) Ultimately, governments should seek to have broad tax bases with easily collected taxes. Ideally, the taxes should not aim to inﬂuence business activity or taxpayer behaviour, apart from some exceptional cases. Further, and in particular for developing countries, the barrier to entry into the formal sector should be low. Presumptive taxes are often used in developing economies in an attempt to reduce such barrier to entry and capture more of the large informal sector in such countries. The tax system should attempt to collect suﬃcient taxes to provide for the services and capital infrastructure oﬀered by the government and its administration. The suﬃciency should be planned on the long term, with the budgets reﬂecting the funding of the immediate needs of the state. Care must be taken that immediate funding issues do not crowd out long-term planning or extract too much to the extent that they prevent future tax revenue. Such long-term planning introduces stability for the taxpayer and the government, and budgets are easier to draft. Stability also provides taxpayers with reasonable expectations prior to the budget. Coupled with stability is the need for the elasticity of taxes in order to facilitate ﬂexibility in the budget for unforeseen economic events or social needs. Elasticity in the taxes levied allows ﬂexibility in upturns and downturns in the economy. Elasticity also implies that tax revenues will grow faster than the economy in upturns, but reduce faster in downturns. The clear risk for states is the temptation to spend at unsustainable levels in upturns and insuﬃciently provide for needed increased spending in downturns. Tax policy must equally consider inter-nation equity. The fact that each state receives equitable allocation of revenue from cross- border transactions has grown in importance in recent years. These considerations impact the tax treaty policy of the particular state. 2.3. Rule of Law 2.3.1. Introduction and rationale for the Rule of Law Taxation, at its heart, deals with the relationship between citizens and the state. The Rule of Law is the main principle regulating the manner in which the state uses its coercive power to raise funds from citizens for the purpose of expending these resources on public goods. The need for the Rule of Law arises when society accepts the undisputed authority of a central government. Modern states are enormous organizations that command great power and vast resources. The Rule of Law is the main legal constraint that checks the exercise of public power; it is the most fundamental legal principle governing the relationship between a citizen and the state. The social contract, which explains that consent is the basis on which citizens surrender some of their freedom to the state in exchange for protection, is closely correlated with the Rule of Law, but it is essentially a principle of political theory, despite being described as a “contract”. From a legal perspective, authority and the capacity to command are deﬁning features of supreme central governments. During earlier periods of human history, authority was represented by the power of monarchs, the church or tribal rulers. A monarch, for example, was the source of law and the maintainer of order. Such conﬂated forms of supremacy have now mostly been disaggregated and passed on to sovereign states in which parliaments have the main law-making power, while independent courts in conjunction with prosecuting and policing agencies maintain order. A deﬁning feature of the Rule of Law is that it provides security for the rights of individuals against the power of parliaments, law enforcement agencies of the state, as well as the judiciary. 2.3.2. Functioning and presence of the Rule of Law in a legal system The Rule of Law has been in existence in some shape or form since ancient times due to its function of protecting citizens against arbitrary exercise and abuse of power. A basic sense of order is achieved in a particular society when the state and citizens adhere to the Rule of Law. However, societies are not homogenous. The manner in which any society wishes to order its aﬀairs at a particular point in time diﬀers from how others may wish to do so. Accordingly, it is not possible to deﬁne the content of the Rule of Law outside of a historical and geographical context, nor is it possible to oﬀer one universal meaning. The Rule of Law has been deﬁned in diﬀerent ways over the course of history, taking its meaning from the particular exigencies that a community seeks to assert against a state at a given point in time. It is important to make clear that the Rule of Law can function and achieve its purpose without a precise, comprehensive or universal deﬁnition. The absence of a written deﬁnition for the Rule of Law in a particular legal system does not mean that the principle is not present in that system, nor that it does not apply to the tax law of a country. In fact, the Rule of Law is almost never deﬁned in legislation, as is the case for most key principles of law. In some legal systems, the principle is expressed by diﬀerent terms, such as “government under law” or “governments of laws and not of men”; they all seek to achieve similar results. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 10 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) 2.3.3. Nature and features of the Rule of Law As in ancient times, the Rule of Law today may mean diﬀerent things to diﬀerent people. At the present time, it is often – but not universally – acclaimed to be a non-negotiable demand of human dignity or even a universal human right (although the latter claim invites considerable confusion). Since antiquity, philosophers and lawyers have held many theories about the Rule of Law. Common aspects include that the Rule of Law (i) has the purpose or function of protecting people against anarchy; (ii) allows people to plan their aﬀairs with conﬁdence, certainty and knowledge of what the law requires and sanctions; and (iii) protects people from arbitrary or capricious exercises of power by state oﬃcials. In present times, adherence to the Rule of Law is universally seen as an essential condition for people’s economic wellbeing, as explained in the 2012 UN Declaration on the Rule of Law: We agree that our collective response to the challenges and opportunities arising from the many complex political, social and economic transformations before us must be guided by the Rule of Law, as it is the foundation of friendly and equitable relations between States and the basis on which just and fair societies are built. […] We are convinced that the Rule of Law and development are strongly interrelated and mutually reinforcing, that the advancement of the Rule of Law at the national and international levels is essential for sustained and inclusive economic growth, sustainable development, the eradication of poverty and hunger and the full realization of all human rights and fundamental freedoms, including the right to development, all of which in turn reinforce the Rule of Law. In the last two centuries, features of the Rule of Law have been articulated in western democracies. In that context, the Rule of Law’s features are derived from natural law inspired by moral philosophies, religious precepts and/or reasoning. For the English lawyer A.V. Dicey (1897), the Rule of Law meant something very speciﬁc, i.e. that nobody is above the law, meaning that all persons, including government oﬃcials, politicians and judges, are equal before the law. In some European countries (e.g. France), this was not always the case, as separate courts had to be set up to deal with administrators who were not subject to ordinary legal rules. Further, Dicey emphasized that no person should be punished except if they breach the law as determined by the ordinary courts of the land. Lastly, the Rule of Law had to pervade the law, written and unwritten, in order to achieve security for citizens. Judges have a special role to play in ensuring that the Rule of Law pervades all aspects of a legal system, since they concretize the Rule of Law through application to actual cases. Tax cases accentuate this role of judges as the ultimate check on the state’s reach into the pockets of citizens. More recent expressions of the Rule of Law, such as by Lord Bingham (2010), identify a number of features embedded in the principle: The law must be accessible and, so far as possible, be intelligible, clear and predictable; Questions of legal right and liability should ordinarily be resolved by application of the law and not by the exercise of discretion; Ministers and public oﬃcers at all levels must exercise the powers conferred on them reasonably, in good faith, for the purpose for which the powers were conferred, and without exceeding the limits of such powers; The law should apply equally to all, except to the extent that objective diﬀerences justify diﬀerentiation; Means must be provided for by the State to resolve, without prohibitive cost or inordinate delay, bona ﬁde civil disputes which the parties themselves are unable to resolve; Judicial and other adjudicative procedures must be fair and independent; The law must aﬀord adequate protection of human rights; and There must be compliance by the state with its international law obligations. Not all of these aspects may be universally accepted as part of the Rule of Law by all nations that adhere to the principle. For example, it may be questioned whether the last three aspects listed in the above quote are universally followed. There are examples today of governments that do not give adequate protection to human rights or fail to adhere to peremptory norms of international law, such as not torturing citizens. Lord Bingham’s articulation of the Rule of Law, while legal reality in some countries, may therefore be aspirational for others. Even when Rule-of-Law countries recognize a certain number of human rights in their constitutions, this does not necessarily translate into these rights receiving adequate protection. This raises jurisprudential questions as to whether human rights are legal rights or something diﬀerent, such as political or moral rights, and consequently whether they belong, as a broad family, to the Rule of Law. An ever-growing catalogue of rights are claimed today to be human rights. This may range from civil rights (such as the right to free speech, freedom from slavery, equality before the law, the right to a fair trial and the presumption of innocence) to rights of socio-economic nature (such as the rights to work or education), as well as more liberal rights (such as the right to an ecologically sound environment, the right to social transparency and the right against poverty). It is hard to connect the Rule of Law to some of these rights. Yet, the Rule of Law can be an important adjunct to concretize certain types of human rights, whether they are recognized by a government or not. Human rights, such as the rights to (i) be presumed innocent until found otherwise by a court of law; (ii) have access to the courts and a fair trial; or (iii) demand just administrative action are derived from the Rule of Law, since they all concern the exercise of state power through the law. It may be harder to use the Rule of Law in a country in which the government Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 11 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) or its laws do not expressly recognize these rights or even actively suppress them, although it is not impossible, especially if the courts are willing to interpret the law according to the tenants of the Rule of Law. While the Rule of Law has received wide-scale attention in western countries, it cannot be monopolized by any group. Studies that have investigated the analogies in Islamic Sharia law show that basic principles such as justice, equality and fairness are compatible. Perhaps even more telling is the insight that the Rule of Law is prone to failure in secularized countries if it is conﬁned to formal legality, especially when underlying moral or ethically reasoned principles are discredited or contested too much. By contrast, in Islam, the basis of law does matter, because it is indisputably divine. At speciﬁc points in history, it was not always apparent whether the Rule of Law had any impact on the content of laws or their substantive impact. It goes without saying that it is preferable to have the rule of good law and not the rule of bad or even immoral law. Even where the Rule of Law prevails, the substance of the law may be such that when applied strictly according to the Rule of Law, it may lead to unjust results. The most precise, detailed and general rules, if they are unsound, may, in their cumulative eﬀect, threaten the whole legal system and undermine freedom. The Rule of Law in such a formal sense does not deal with lawfulness or justice, but merely with the legal organization of societies. Historical examples in which the Rule of Law in a formal sense was used to subvert freedom and basic human dignity can be found in Nazi Germany or apartheid South Africa: clear abuses of state power through laws that formally complied with a narrow understanding of the Rule of Law were perpetuated. An opposing understanding of the Rule of Law in its true sense postulates an expanded function that is not merely formal in nature. For example, legality, which is the opposite of a rule of discretion, is universally understood to be part of the Rule of Law in its true sense. Under a rule of discretion, the rights of persons are determined by others exercising discretion obtained from so-called “open-ended legislation” that does not specify detailed legal rules, relying thus, to a greater or lesser degree, on that discretion only. The Rule of Law envisages a legal system in which a citizen must be able to plan his or her life with some certainty and be able to establish his or her rights according to formal detailed rules that are intelligible and publicly accessible. The Rule of Law in this true sense is not a recent development, but derives from antiquity, as can be seen in the phrase attributed to Cicero that “we are all slaves of the law in order that we can be free”. Thus expressed, it means that a government, in all of its actions, “is bound by rules ﬁxed and announced beforehand – rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances, and to plan one’s individual aﬀairs on the basis of this knowledge” (Hayek 1944). While the Rule of Law, in its true sense, goes some way to require that laws actually have some meaningful content, it is not an all- embracing concept that acts as a repository for everything that is good in a legal system, nor does it cure all of the system’s evils. In summary, current understandings of the Rule of Law suggest that it is not a mere code for procedural safeguards against how a state exercises its power through laws. In its true sense, the Rule of Law should also impact how the content of law is crafted by legislators and courts. Precisely how (and particularly whether and, if so, which) human rights need to be recognized in the content of the law is an evolving question. In some countries, this may be self-evident, given constitutionally entrenched fundamental rights, while this may be less so in others in which written laws may be silent on the topic. The impact of the Rule of Law on the content of the law is an important universal benchmark in taxation, as the remainder of this chapter will illustrate. 2.3.4. “No taxation without representation” Public consent to taxation is a key political construct of a democratic state. In relation to England, public consent can be traced to article 15 of Magna Carta, 1215, which initiated the transfer of the uncurtailed power of monarchs to omnipotent legislation created by elected parliaments. Magna Carta set out several principles that are foundational to both the Rule of Law and democracy. In western democracies, consent is often linked to the slogan “no taxation without representation”, which was coined in the 18th century when North American colonists rebelled against tax laws imposed by the British Parliament, in which they were not represented. This historic incident was a direct and key cause for the American Revolution. There are several historical examples in which a lack of representation in legal processes for the enactment of new tax laws was a key cause for social disobedience, unrest, rebellions or wars, such as the English Civil War of the 17th century, the Hut Tax Wars of the 19th century in Africa and the Russian Revolution of 1905. The Rule of Law requires that all rules or powers must derive from duly enacted or established law. In other words, a jurisdiction in which law and order is maintained in order to mediate conﬂicting interests as opposed to anarchy or oppression requires a political society that rests on legal relations out of free will and not out of force. Taxation brings out this feature of the Rule of Law in the strongest possible sense. Modern democratic constitutions centred on the Rule of Law provide mechanisms for substantial inﬂuence of the whole citizenry of a nation (e.g. through periodically elected legislatures). Majorities obtain power to implement distributive taxes in this way. The concentration of economic wealth is often skewed, such that capital ownership is concentrated in a minority. In reality, therefore, redistributive taxes democratically imposed in a nation-state context become legal tools for (poor) majorities to appropriate the wealth of a (rich) minority. Whilst this is the theoretical position, the reality is that especially income tax systems have, for a long time, evolved in a way that they contain wide-ranging allowances or reliefs for capital owners. These tax Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 12 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) reliefs are often justiﬁed on the basis that they encourage savings or are necessary for countries in order to compete for attraction of mobile or long-term investment. Globalization has had a profound impact on the way tax laws are created today. The Rule of Law must be accommodated by legitimizing ongoing revisions and reforms of tax laws. The need for governments to be involved in or cognisant of the global coordination of tax law reform is required due to the complexity of capital and ﬁnancial markets, inter-state competition for scarce capital and the operation of modern businesses. The ability of national parliaments to process these international factors or cope with their pressure is often limited, and hence, there is a need to participate in global or regional forums. The basic problem of law-making for countries that operate and compete in a global context is how to accommodate quasi- legislative bodies and international organizations that may exert considerable inﬂuence over the content of tax law but in which citizens of a particular country are not represented. Governments frequently belong to international or regional organizations or looser forms of associations or frameworks, which all may aim to inﬂuence, coordinate or harmonize legal reforms or formulate model laws. As a result, many governments, as a matter of routine, undertake to reform their laws, and some even do so as a precondition for international ﬁnance or investment. Actions like these may lead to political or even legal commitments being given to external bodies or institutions, thereby constraining unfettered sovereign capacity to enact original tax laws. A careful balance is therefore required in order to ensure that ongoing tax law reforms remain legitimate in the eye of the citizens. In the modern age, adherence to the Rule of Law means that the expenditure of public ﬁnance is as ﬁrmly governed by law as the capacity to raise taxes. How a government may spend tax revenues should depend wholly and solely on pre-determined laws enacted by elected parliaments. Good governance requires control and audits, often exercised by an Auditor General, which is the primary means of securing that money paid by taxpayers is expended by the government in accordance with the intention of laws democratically established. The reality is that public ﬁnance law is often technocratic and out of the sight of citizens, meaning that it may be less robustly checked or contested. Civil society and the media play an important role in bringing to light any misappropriation of the expenditure of public money. 2.3.5. Certainty: Interpretation of law The process by which the Rule of Law is concretized (i.e. becomes reality for citizens and taxpayers) gives rise to legal certainty or uncertainty. This is because the grand ideals encapsulated in the Rule of Law require the intervention of fallible human beings in order to turn them into reality for others. Dicey and others held the view that the task of judges was to ensure that the Rule of Law pervaded a constitution, whether it was written or unwritten. The rule of law is not a mere adornment of a constitution, but has to be realized in the actual workings of the law. This approach means that the Rule of Law as a principle turns into legal reality for citizens and taxpayers when laws are interpreted and applied on a daily basis. The Rule of Law therefore involves an important practical aspect: it secures, for citizens and taxpayers, the possibility of predicting the activities of the law-deciding (judges) and law-applying agencies (administrators). In this way, citizens are enabled to adapt their conduct and predict the lawful outcome of their actions accordingly. In other words, the practical application of the Rule of Law through legal interpretation elicits situations in which there is or is not legal certainty. If there is conformity between the law-applying and law-deciding functionaries and the law is already laid down, a situation of legal certainty prevails. There is thus a close connection between legal certainty and legal interpretation of the law, as the Rule of Law requires that the process of interpretation of the law itself should be governed by law. In other words, legal interpretation is not based on discretion, nor is it purely subjective. The task of formulating such a theory of legal interpretation of the law to be applied to law generally rests with the highest courts of the land, particularly in common-law countries in which strict rules of precedent order the hierarchy of legal sources. A country’s senior judges are very important guardians of the Rule of Law, as it is through their control of legal interpretation theory that the actual eﬀect of the law is concretized for citizens and taxpayers in any given case. Legal certainty established by the Rule of Law also has an impact on the content of the law. Parliaments and legislators are thus required by the Rule of Law to design legislation that enables citizens to know and predict their rights. Therefore, laws must be intelligible and not overly complex or vague, and they should be general but precise. If laws fail to meet these objectives, they import or require the exercise of discretion in order to decide what they actually mean in a given concrete case, resulting in uncertainty. While interpretation of the law is not a purely subjective process, appearances of subjectivity can indeed erode the legitimacy of judicial decisions. The judiciary, as the ﬁnal preserve of the Rule of Law, therefore needs to be ﬁercely unbiased and seen as impartial. The process of judicial appointments is key in selecting appropriately skilled and experienced judicial oﬃcers. Taxation often involves specialized courts or tribunals, which can signiﬁcantly enhance the Rule of Law and legal certainty. Compromising Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 13 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) appointments to such specialized tax courts or bodies need to be carefully guarded against. For example, appointing a former activist or a family member of a senior revenue oﬃcial as a tax judge, although they may be suitably qualiﬁed and unbiased, may nonetheless erode public conﬁdence because such appointments undermine the appearance of an impartial court. A further outﬂow of certainty under the Rule of Law is that laws should take eﬀect for the future. Otherwise, citizens will not be able to know what their rights are or how to plan their conduct. The Rule of Law therefore serves as the basic reason why parliaments generally should refrain from enacting retroactive or retrospective legislation. Retroactive legislation is legislation that provides that at a past date, the law shall be taken to have been that which it was not. Retrospective legislation imposes, for the future, new results in respect of a past event. Both forms of legislation oﬀend the predictability required by the Rule of Law. Retroactive legislation is more objectionable because, at the point in time at which a citizen undertook action from which legal consequences would ﬂow, it did not exist. 2.3.6. The principle of legality In some legal systems, the principle of legality is widely written about, and judges or commentators may view it as part of the Rule of Law or even as the same. Further, the principle of legality is often linked to the rise of administrative law when it may operate as a repository of fundamental norms about how public power ought to be used. The principle generally expresses the idea that the exercise of public power is only legitimate when lawful. In this sense, it may act as a safety net, and it is not always written down in formal legislation, but may be viewed as implicit whenever legislation deals with executive or administrative acts and competencies. There is jurisprudential discussion as to whether the Rule of Law has a wider or the same ambit as the principle of legality. This is in part because, in some countries, especially those without a comprehensive constitution, the principle of legality was developed as part of administrative law, which itself may have evolved. In a narrow sense, the principle of legality is not understood to require the exercise of public power with reasonableness and fairness. For example, it may not yet cover procedural fairness, such as the giving of reasons by an administrator for decisions taken in terms of the legislation granting discretionary power. It may also not demand proportionality, which is the other half of reasonableness, unless one argues that it would be irrational or a misconstruction of power not to give due regard to proportionality. There is, however, clear evidence that proportionality works in concert with the principle of reasonableness as a general principle of international and EU law by giving speciﬁcation to reasonableness in particular cases (i.e. by requiring a rational connection between ends and means). Proportionality may therefore apply in cross-border tax situations as a general principle of law, whereas some tax systems may not yet recognize such an overarching requirement at the domestic level. However, what is certain is that the principle of legality has expanded with the rise and development of administrative law and human rights in some jurisdictions. This can be seen in how some courts view their power to review discretion (generally termed “judicial review”). For example, in the United Kingdom, Lord Woolf held that when a fundamental right is engaged, the options available to the reasonable decision-maker are curtailed because it is not open to such a decision-maker to risk interfering with fundamental human rights in the absence of compelling justiﬁcation. He said that even the broadest discretion is constrained by the need for there to be countervailing circumstances justifying interference with human rights; it operates as a spring: the more the exercise of public power presses down on constitutional or fundamental rights, the more the law’s resistance increases, requiring cogent reasons for the limitation before giving way. Thus, nowadays, there is emphasis in some countries on giving reasons and justiﬁcation for decisions by public oﬃcials. These considerations apply to tax administrators without deviation. Judicial review of administrative actions cover decisions (or even the failure to decide) of tax administrators. Judicial review was developed in some countries because the courts recognized that they determine the scope of administrative discretion through an exercise of statutory interpretation. Interpretation of the law, which is central to concretizing the Rule of Law, includes the identiﬁcation of fundamental rights, whether they are written or unwritten. In this way, these courts consider whether administrative decisions negatively or positively aﬀect fundamental rights and whether it is justiﬁed. The Rule of Law can thus be seen to be expressed by the principle of legality and may, for some jurisdictions, be synonymous in the arena of judicial review. Most courts in judicial review proceedings require that the exercise of public power by the executive and other functionaries of the state should not be arbitrary. Decisions must be rationally related to the purpose for which the power was given. Otherwise, they are, in eﬀect, arbitrary and inconsistent with this requirement. Some courts understand this minimum requirement to mean that executives and functionaries of the state must always act in good faith because rationality requires that they should not misconstrue their legislative powers. In the area of taxes, there are many opportunities for overreach. Tax legislation, for example, grants the authority to a tax administration to make regulations that will govern the procedure for handling objections to tax assessments. Such regulations become ultra vires (beyond the powers) and breach the Rule of Law if they prohibit taxpayers from ﬁling an objection in speciﬁed circumstances (e.g. if a ﬁne is involved) because the statutory discretion is misconstrued in a way that the fundamental rights of taxpayers may be curtailed. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 14 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) An important limitation to the power of judges to review decisions by the executive and functionaries of the state is that the courts are not able to interfere with a decision simply because they disagree with it. This limitation, however, only applies to rational decisions, and therefore, courts have the power to set aside or declare invalid a decision that is irrational. Judges generally should give reasons for their decisions, since they too should act within the bounds of the Rule of Law and adhere to the principle of legality. In this way, parliaments and courts are prevented from acting arbitrarily or capriciously when making or interpreting laws. 2.3.7. Law – not discretion – and the exercise of public power Under the Rule of Law, questions of legal rights and liabilities should, as a principle, be resolved by the application of the law and not by the exercise of discretion. However, as the discussion of the principle of legality in section 2.3.6. indicated, discretionary decision-making powers are awarded to executives and other state functionaries by parliaments. It is worth stressing that the conferring of discretionary power on public oﬃcials should be the exception and not the rule. This is because discretion is contrary to several aspirations of the Rule of Law; it means uncertainty, lower levels of predictability and a higher possibility that chance will determine outcomes. The eﬀects of arbitrariness, which is the result of discretion, can have a very negative and corrosive impact on a country. Corruption often involves the criminal exercise of public discretion. Less severe counterproductive use of discretion includes indecision and delay. In the area of taxes, discretion-based rules to settle disputes between tax authorities and taxpayers, particularly in the cross-border context under bilateral tax treaties (e.g. the mutual agreement procedure), are prone to indecision and delay. The Rule of Law and the principle of legality require that the exercise of public powers be carried out in good faith, fairly and reasonably, and strictly for the purpose for which the power was conferred and without exceeding those powers. This applies at all levels, from ministerial to every level of civil servant. There is evidently tension between the Rule of Law and the wide powers of a parliament. For example, even if a legally functioning parliament awards absolute and wide discretion to, say, the head of the government, such a power, although conferred legally, may still be contrary to the Rule of Law because, in eﬀect, such a law abrogates the Rule of Law. However, it is also unrealistic to expect that no discretion in legislation should be allowed by a parliament. No legal system can operate without giving discretion at all. Accordingly, tension exists between the need under the Rule of Law to prevent and correct administrative errors and to preserve the administrative expertise that is necessary for the orderly functioning of the government. In recent times, one area in which this tension has resulted in diﬀerent legal outcomes is the question of whether the Rule of Law requires that a government foster a culture of justiﬁcation and explanation for all decision-making that aﬀects, for example, taxpayers. As was discussed in section 2.3.6. with regard to the principle of legality, judicial review requires courts to check that decisions are not arbitrary, but this does not mean that the judge must take a view on whether the given reasons are correct or not. However, modern rights culture has been viewed by the courts of some countries as meaning that relevant values, such as human rights, must be demonstrably considered or given weight when deciding on the legitimacy of administrative decisions. The range of results open to the oﬃcial is therefore necessarily constrained to only those that are consistent with the applicable values. Evidently, written reasons, often in the style of legal reasoning, will therefore be required, and courts would need to take a view on whether these reasons are coherent and consistent with applicable fundamental norms. The Rule of Law, in its modern understanding in a constitutional state in which basic human rights are enshrined, thus makes decision-makers accountable for these fundamental values without removing their discretion. It does not extend to the capacity for judges to tell oﬃcials which results to reach. In other words, judicial review is also evolving because of the inclusion of human rights in the Rule of Law doctrine, as some courts are shifting their focus onto the justiﬁcations given by decision-makers. A contested area is that of whether a legal duty exists for decision-makers to provide written reasons for every decision aﬀecting, say, a taxpayer (this is particularly contested in the area of international exchanges of taxpayer information pursuant to discretion granted to tax administrators under treaties). A duty to provide written reasons for every tax-administrative action aﬀecting taxpayers may threaten the use of discretion due to the range and volume of decisions. However, there are also clear examples of when discretion in tax law can never be justiﬁed under the Rule of Law. If, say, legislation that imposes a proﬁt-based tax (e.g. income tax) allows tax administrators to determine “any other deduction prescribed by regulation”, the policy responsibility and eﬀective legislative power to establish the tax base is transferred to unelected administrators answerable only to the executive. Tax legislation of this nature breaches the “separation of powers” doctrine. 2.3.8. Equity in tax law Equity in taxation was discussed in section 2.1.2. It is discussed here in the context of the Rule of Law as it relates to two areas of tax law. The ﬁrst is justice, which reﬂects a community’s sense of the fairness of a tax system, and the second is equality before the law, which refers to the tax legislator’s ability to identify dissimilar situations and apply appropriate legal rules to each. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration (P. Pistone et al. eds., IBFD 2019), Books IBFD (accessed 23 April 2024). 15 © Copyright 2024 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information. Exported / Printed on 3 Oct. 2024 by Universita Studi di Torino. Fundamentals of Taxation: An Introduction to Tax Policy, Tax Law and Tax Administration - Chapter 2: Principles of Taxation - Books (Last Reviewed: 1 May 2019) 2.3.8.1. Justice, fairness and ability to pay There is a link between justice and ability to pay as economic and political aspirations for a good tax system. Ability to pay plays a part in various technical ways in the manner in which revenue-raising tax laws should be designed. For example, the realization principle in income tax means that tax liability should only be calculated, and the obligation to pay should not be imposed before the point in time at which the taxpayer obtains ownership of the asset (e.g. cash or a bartered item) that accumulated from the underlying taxable transaction. Further, setting the rate of a tax is an important aspect of ability to pay. The clearest example is progressive income taxes that are imposed at higher rates on those with more income. Ability to pay may also refer to justice (fairness) in taxation, which can be seen in the amalgam of a community’s impression of whether a tax regime is “fair” in respect of the circumstances during the time at which a view is expressed. These debates are invariably more political than legal because they concern the underlying political theory and construct, such as the social contract. Political or popular debates about fair tax laws often concern the linkage between revenue-raising laws (which, by themselves, may be perfectly just and reasonable) and the legal expenditure framework. An overall impression of unfair or unjust tax law may form in a community due to, say, maladministration of tax expenditure laws or the occurrence of wide-scale state corruption. When tax laws contain too much discretion, for example, to grant concessions to groups of taxpayers, it may equally lead to impressions of unequal or unfair tax law. 2.3.8.2. Non-discrimination The Rule of Law requires that the law apply equally to all, except to the extent that objective diﬀerences justify diﬀerentiation. Discrimination should be distinguished from diﬀerentiation. Diﬀerentiation involves the identiﬁcation of objective and rational diﬀerences as a justiﬁcation for separate treatment. Discrimination, on the other hand, treats objectively similar subjects diﬀerently based on a speciﬁc ground or feature that the two subjects do not share. Overall, the laws of most democratic states apply to all citizens on the same basis, namely that irrelevant distinctions based on a person’s race, religion, political aﬃliation or inﬂuence should not be drawn. The grounds upon which discriminatory treatment is or should be prohibited are not exhaustively catalogued by the Rule of Law. This prohibition may be codiﬁed in a country’s own constitution, for example, when it enshrines human rights values, or by international law commitments. Legislation should not allow discrimination through awarding discretion-based decision-making power to executives or functionaries of the state. Discrimination based on irrelevant grounds can lead to decisions being set aside under judicial review proceedings. Equality of treatment in tax law has been translated into various types of bans on discrimination, although the range and depth may vary considerably between countries. For example, one may expect that an income tax system would not discriminate based on gender or marital status by, for example, allowing or disallowing tax deductions because of being married or unmarried, male or female, and so on. 2.3.9. Other aspects of the Rule of Law 2.3.9.1. Dispute resolution and fair trial When parties cannot resolve a disputes with an agreement, in a Rule-of-Law system, the state has an obligation to supply means through which such disputes may be settled without prohibitive cost or inordinate delay before impartial judicial oﬃcers in a fair procedure. This obligation of the state translates into tax regimes in several ways. For example, an administrative procedure should be provided to taxpayers to object to tax assessments, which serves to ﬁlter disputes that are not worthy of a court’s attention (e.g. to correct computational errors or mistakes). Further, countries often establish specialist tax tribunals (quasi-courts), specialist courts and/or less formal forums to settle small tax claims. The principle of legality and its outﬂows, such as administrative justice, should permea

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