Evaluating Tax Systems

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Those who implement the tax systems, as well as taxpayers, often use criteria to evaluate the system.

Sufficiency

Sufficiency refers to if the tax system is actually generating the amount of revenue that it was expected or budgeted to. Although revenues and expenditures of the government can be difficult to estimate, it is important that the revenue is generated to continue to fund the programs. Although governments do their best to predict this, some unforeseen circumstances, such as wars, natural disasters, pandemics, and economic events can greatly affect the amount of revenue generated by taxes or the expenditures needed to aid in these events.

Static vs. Dynamic Forecasting

There are two approaches to forecasting—static or dynamic.

• Static forecasting ignores any new information and projects based upon current information. That is, this method does not account for any taxpayer changes.
• Dynamic forecasting, however, attempt to account for taxpayer responses to changes. Although these predictions may be inaccurate, it is useful to attempt to identify these responses. These projections, though, are only as accurate as the correctness of the assumptions made.

Income vs. Substitution Effects

It is difficult to predict a taxpayer’s reaction to tax increases as it will depend on each individual’s preferences. Forecasters and legislators will assume either an income effect or a substitution effect.

• The income effect predicts that taxpayers will attempt to make the same after-tax amount even with a tax increase by working more.
• The substitution effect predicts that taxpayers will spend less on taxable activities when there is a tax increase to make up for the lower after-tax income. For example, they may do more entertaining at home instead of going out for dinner or to the movies.

The Trade-Offs

When implementing a tax system, there is generally a trade-off between simplicity and fairness. Tax systems that have ease of administration (for example, flat rate tax) generally are most criticized for fairness (not based on ability to pay). The systems that are more complex to administer (for example, graduated tax) are generally seen as most fair by taxpayers. The implementing agencies must determine which they are willing to compromise based on their resources available.

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