Tax is an obligatory charge levied on an entity or an individual, which forms a major source of income for a state and hence is quintessential for its existence. Mostly, the collection of taxes either in the form of direct or indirect taxes ensures the survival of the state. There has been a plethora of reforms in the field of taxation and the method of collection of such taxes. It must be noted that every country has framed its tax policies in such a manner to satisfy the need of the country as well as its people in the best possible way. The history of tax collection dates back to the time where taxes were collected in kind. The modern-day taxation can be termed as an improvised version of theories propounded during the period of enlightenment by great economists like Adam Smith, David Ricardo, etc. We notice that, the system of taxation has undergone a lot of changes and has been modified to suit modern needs.
Adam Smith, the Father of Modern economics, undoubtedly has one of the greatest contributions the field of economics. In fact, the birth of modern economics dates back to 1773, the year when Smith published his world-renowned book, “The Wealth of Nations” where he laid a lot emphasis on taxation which he considered to be an essential fuel factor influencing the growth of a nation. Smith has propounded four maxims wherein he throws light about the relevance of taxes in the modern world and the proper way to collect them. Smith tried to justify the concept of tax by equating it to the returns that the state provides to the citizens.
Smith proposed that taxes should be borne by individuals according to their capacity which paved way for the concept of ‘Progressive Taxation’ which is prevalent in many countries including India. This was under the notion that the person who earns more has actually profited more from the protection of the state and hence it is correct to charge more from him. However on the contrary Smith was against the concept of taxation on wages because he felt wages are mostly equal to the cost of survival of the laborers and any taxation on such wages should be compensated by the employer in the form of an increase in wages. But again, such an increase in the cost of wages would put undue pressure on the employer which might lead to a reduction in employment.
Smith also advocated fairness in the collection of taxes and strongly expressed the need for fixed tax slabs. According to him, any arbitrary tax collection regime will not result in efficiency as there is always an opportunity that mismanagement and malpractice might occur. He felt that when authorities are empowered with the tax assessment, they might misuse their position either in favor or against the person or entity being assessed. He also proposed that such a fixed tax would help in better proportioning and hence reduce the burden on the tax payer.
David Ricardo was a follower of Smith who strongly believed that a manufacturer is at ease when the concept of taxation doesn’t exist. However, he adds that in such a case, the state would have no incentive to regulate businesses and would not be in a position to provide essential services. Thus, the concept of taxation has been used to defend the state’s action of regulating businesses. Ricardo followed a static analysis wherein he tried to compare various equilibrium positions wherein taxes are altered to get different tax levels. He tried to connect it with the ‘Theory of Value’ and thereby extract insights out of it. He equated taxes on wages with the social benefits provided to them. Ricardo differs from Smith when taking into account “Tax of Wages”. He strongly felt that an imposition of tax on wages with lead to a popular demand for increase in wages. This will eventually lead to increase in nominal wages and reduce the profit. Ricardo said that this leads to the same situation as an increase in taxes on profit. He felt that if the taxes collected on wages are used for public works, then it would lead to more labor demand. On the other hand, if labour wages increase, it might disincentivice the capitalist to increase his labour demand. As a result of that, the demand for labour reduces and hence leads to more unemployment.
The primary difference between Ricardo and Smith can be found in relation to the concept of Margin. Smith was of the opinion that the produce from the land and the raw materials are to be taxed and that should be collected from the land owner. But, Ricardo was of the opinion that an incidence of tax would increase the marginal cost and would thus lead to price rise. Hence, he vehemently opposed tax on raw produce especially in the field of agriculture. Smith believed that an increase in taxes results in an increase in wages. This might result in an increase in prices of commodities being produced and result in reduced demand for the product. Contrary to this argument, Ricardo propounded his view wherein he says that an increase in wage would result in an increase in price level of products. This increase is partially borne by the customers and partially borne by the producers. The producers tend to forego some percentage of profit as a result of such an increase in taxes.
The relevance of Smith’s maxims on taxation is seen even today. When we consider the modern day taxation in almost all nation states, we can see his ideas taking a front seat. For instance, in India there is a system of progressive taxation, as also seen in the Union Budget 2020. This is in line with Smith’s first maxim which advocates for higher taxes for those who are capable of paying them. There are numerous laws governing the tax regime in India which provide a systematic framework and prevents the situation of ambiguity and confusion that usually arises in the absence of a framework. These laws are in tandem with Smith’s second maxim. The establishment of various departmental bodies such as the Income Tax Offices and separate mechanisms for collection of indirect taxes and to oversee wrong doings in the tax regime. Such an institutional setup reduces the deadweight loss as the number of officers dealing with the collection of taxes is fixed and extra personnel’s can be diverted to other productive activities. Moreover the framework prevents extortion. This is completely in line with Smith’s final maxim. In India there is a stipulated time period during which the taxes are to be paid. This comes at a time during the end of harvest season and a period where there is an increased investment as a result of the January effect. This substantiates the third maxim wherein Smith lays emphasis on stipulated time for collection of taxes wherein the taxpayers are comfortable to pay it. Thus, the relevance of Smith’s maxims on taxation is elucidated and substantiated with a suitable example from Indian context. It is interesting to note that the system of taxation is almost similar in various nations across the world spanning from Western countries such as the United States, Great Britain to small island nations in western Pacific Ocean.
Ricardo strongly believed that an imposition of tax on labour would lead to an increase in wages and would result in a reduction in the profit of the firm. Thus he tried to prove that the tax on wages could lead to a deterioration in the tax earned on profits and mostly nullify it. When we look at Indian perspective, it can be seen that people in the lower income bracket (about 80% of the population) need not pay taxes. This can be attributed to the fact that if a tax is imposed on this income, the wage rate would have to go up because most of these people are earning at subsistence level and hence the increase would eat up the profit of the firm. As the profit is reduced, the tax that can be collected will also reduce thus bringing back the old situation. The government on the other hand provides certain incentives on taxation for small enterprises. This is done in order to promote and encourage small entrepreneurs to increase production and hence employ more people. The modern day relevance of his proposition wherein he advocated a fluctuation in nominal wage in order to maintain the real wage is evident in the labor market. The salaries and wages then become linear with the inflation rate.
Thus, Smith’s and Ricardo’s views and impact on modern taxation policy are relevant even today.
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