Tax systems are an important and integral part of any economy around the world. Taxes are imposed by the governments on various activities and it eventually becomes an important source of revenue generation for the governments. Governments use tax revenues in order to finance their public expenditures. Besides that taxation systems are also a very important tool for the governments in order to influence the aggregate demand and consumer expenditures in the economy. This means that the governments influence the way people spend their money. This in turn influences the rate of inflation and employment in the economy.
On a broader perspective there are two types of taxation systems namely direct taxes and in direct taxes. Direct taxes are taxed charged on one's income and they cannot be avoided as they are charged at source. Examples of such taxation system include income tax and corporation taxes. In contrast, indirect taxation systems involve charging taxes on one's consumption expenditures such as sales tax and import duties. These taxes can be avoided since the consumer will not have to pay a tax on a certain product if s/he decides not to purchase it. When one pays a tax to the government, s/he pays it out of his or her income which means that the income after tax, referred to as the disposable income, of the tax payer will reduce. Therefore according to economic theory a high tax rate means that the incentive to work would be less as the disposable income will reduce.
Every economy around the world has both direct taxes and indirect taxes. What attracts a greater debate from the economists is the way the tax structure of a country is designed. This is because each economy has people belonging to different income groups. Generally these classes are divided into high income groups, middle income groups and lower income groups. Each income group is supposed to pay taxes in most economies. However, it is the structure of the taxation systems that decide to what extent the burden if tax will fall on a particular income group.
When it comes to types of tax rate structures, there are primarily two types of tax systems that exist. These include progressive taxes and regressive taxes. Under progressive tax systems, tax rates are directly proportional to the income levels of a tax payer. This means that the higher a person or a company earns, the higher taxes that person or the company is liable to pay.
Contrary to the progressive system, under the regressive taxation structures, tax rates are inversely proportional to the income of the tax payers. This means that the higher one earns, the lower tax that particular tax payer is liable to pay (Barwick et al., 1998).
The economic theories asserts, that in order to acquire benefits from the taxation system it is of immense importance that taxes are fair. This means that not only the taxes should justify their duty of acting as a tool in achieving the government's economic objective, but also the revenues generated from the taxes should be enough to justify the costs of tax collection (Becsi, 1996).
Many economic theorists and most governments do not see the regressive system of taxation as a fair tax. This is because under this system, the government is more dependent for the tax revenues on the lower income groups as they are the tax payers at the higher rate. This means that it is likely that the revenue generated from the taxation might not be enough to cover the costs of tax collection (Golab, 1996). Moreover, it would also decrease aggregate demand and in turn economic growth if people are left with little disposable income and as a result, their consumption expenditure decreases (Jorgenson & Yun, 1991). This is against the economic objective of most economies. The more favoured system is therefore the progressive tax systems.
As progressive as it might seem, the progressive system of taxation has also attracted its own share of criticism and not many economist agree with the idea that the system in its literal sense, is beneficial for the economy and the achievement of economic objectives (Fougere, & Ruggeri, 1998). It must be notes that in the most free market economy systems the highest earning group is the huge corporate house and primarily the corporate sector that is involved in the economic activity. It is this particular group that contributes most to the economic growth, gross domestic product and sustaining employment rates of the country (Atkinson, 1996). This means that under the progressive taxation structure, the highest earning group remains the highest taxpayer as the tax rates are directly proportional the income levels. Likewise, the lowest earning income group would be charged with the minimum taxes and the non-earning group would not be required to pay any tax. This means that the strongest revenue generator for the economy supports the weakest contributor to the economy (Gale, 1998). In view of many economists, this demotivate the high earning groups as this provides them with less incentive to work and as a result the economic growth might slow down. As a result the gross domestic product of the country will decline and in a long-term and in extreme circumstances, the fall in aggregate output can result in fall in exports thus pitting negative pressures on the balance of payment.
Keeping in view the lesser practical implications of imposing the progressive structure of taxation, many governments including the United States of America introduced a federal flat tax rate system (Ireland, 1994). In literal sense under a true flat rate tax structure, all taxable incomes are taxed at constant rates regardless of the tax payer belonging to a high or low income group. This means that all income groups will bear the same burden of tax rates. However, the United States of America uses the flat rate structure with some modification and brings it closer to the characteristics of the progressive taxation structure. The United States of America uses the marginal flat tax system, which in essence follows a progressive structure of taxation (Wieler, 1998). The only difference is that above the maximum point of tax deduction, all further taxable incomes are charged at constant tax rates. Moreover, certain funds are also not considered as part of income.
As stated earlier, the currently applies taxation structure in United States of America is although a flat tax system but is closer to a progressive tax rate system. Since the current economic crunch has resulted in the decline of incomes for many people in the country while many are unemployed, this means that a particular group of people bears all the burden of taxation and supporting the economy. This has resulted in attracting immense criticism from the economists.
According to Piketty and Saez (2007), the current taxation system is not really progressive and beneficial for the economy as it seems. Pickety and Saez (2007) argue that the current taxation system is not only disadvantageous to the high income groups as it pressurizes their disposable income but it also has negative impact on the middle income groups as well as the lower income groups, who under the progressive tax system are low tax payers (Golab, 1995). This is because whenever the lower and middle income groups will see a rise in their incomes, they would not be able to acquire the benefits from that rise in income as their taxable income will increase with the rise in their nominal income thus resulting in a low disposable income (Golab,1996). Moreover, since the economic crisis has resulted in constantly increasing inflation rates, the real value of money and in turn the real income of the taxpayer also reduces (Roberts & Sullivan, 1996). Therefore under the currently imposed system the earner is not left with much incentive to work as the real disposable income that the taxpayer is left with at the end of the day is not optimum. For people, whose main motive of taking part in economic activity is monetary gains, this will be less incentive and therefore less of such people would be willing to seek employment (Altig et al., 1997). This in turn would result in an increased unemployment (Foster, 1995). It must be noted that while unemployed people are entitled to receive unemployment benefits, which is an extra unproductive expenditure for the government, s/he does not generate any revenue for the government given that under the current system s/he is not liable to pay taxes (Suyderhoud, Loudat & Pollock, 1994). Therefore, such a non-productive expenditure is financed from the governments funding which comes from the tax payers' money (Altig, 1996). As a result, in order to fund the extra pressures, the government will wither have to curtail the developmental and productive expenditures, which is the right of the tax payer, or will further increase the tax rates so that more revenues could be generated.
Some economists also argue that although the idea behind progressive taxation system is to charge tax…