Tax distinctions
TRADITIONAL public finance literature makes an important distinction between progressive and regressive forms of taxation. In progressive forms of taxation, the tax rate increases with the taxpayer’s income, making it redistributive. The best example for this is income taxation where most countries legally charge a higher rate of tax for high-income earners.
Regressive forms of taxation on the other hand apply the same rate of tax to high and low earners. This in essence means that low-income earners pay a higher share of their overall income in taxes, widening income inequality. Consumption-based taxes, such as general sales tax (GST) or value added tax (VAT), are often classified in the regressive tax category. To illustrate why, assume that there are two individuals A and B who earn Rs1,000 and Rs100 respectively. Both of them buy one soap from the supermarket and end up paying Rs10 in sales tax. Rs10 is one per cent of A’s income and 10pc of B’s income, making the tax regressive and the post-tax income distribution more unequal.
The classification of income tax and consumption-based taxes into their respective categories seems intuitive at first glance but might not hold true in practice. That is because the classification assumes perfect tax enforcement, which we know is not always there.
A simple example can illustrate this. Assume that the same individuals A and B want to buy one kilo of black tea leaves. While individual A buys a popular brand from the supermarket and pays Rs10 in sales tax, individual B buys loose tea from a local informal market where there is no tax.
Classification assumes perfect tax enforcement which may not be there.
For simplicity, let’s assume that the quality of the branded and loose tea is the same. In this case, the sales tax will in fact end up being progressive because both individuals bought a similar product and individual A, who earns more, ended up paying a higher share of income in taxes. Recent work by Pierre Bachas, Lucie Gadenne and Anders Jensen shows this fascinating phenomenon at play, where the interaction between informality and enforcement results in consumption taxes being progressive.
The assumption of perfect enforcement also affects income taxation in a major way. While in theory, we expect high earners to pay a higher percentage of their income in taxes, this can often not hold true in practice for the super-rich. Here, the role of tax exemptions, offshore tax havens and other political economy factors affecting the audit of high-earning individuals play an important role. While these factors can include both legal tax avoidance and illegal tax evasion, it does end up making income tax a much less progressive tax than it would be otherwise.
Recent evidence by Gabriel Zucman and co-authors reveals that even in the US, tax audits underestimate tax evasion at the top of the income distribution.
The method of income tax collection can also play an important role in its impact on the income distribution. In Pakistan, a significant share of income taxes is collected via withholding or collection at source. This, combined with low tax filing rates, means that the withholding tax can often mimic a consumption-based tax. From a theoretical viewpoint, this would make the income tax much less progressive. In developing country contexts where income tax withholding plays a significant role, the progressive impact of income tax can be blunted.
Finally, the simple binary of progressive and regressive forms of taxation simplifies the actual impact of taxes on the income distribution. This is because in reality, progressivity is a continuum rather than a simple binary. Two taxes with a very different impact on the income distribution can both be classified as progressive. This makes it even more important to push towards a nuanced understanding of the impact of taxes on income inequality.
So how can we incorporate the above-mentioned complexity of tax progressivity in our policy design?
The answer is to conduct more context-specific empirical research showing the actual impact of different taxes on the income distribution. While we might have concerns about certain types of taxes being more or less progressive, only rigorous empirical research based on a strong theoretical foundation can help us understand the actual impact of taxes on the income distribution. Such research in the Pakistani context will help inform our policy debate and consequently enable us to design our tax policies in a rigorous and empirically founded manner.
The writer has a doctorate from the University of Oxford and is graduate of the Harvard Kennedy School of Government
Twitter: @KhudadadChattha
Published in Dawn, March 21st, 2021