Adam Smith's four axioms for efficient tax systems

200 years ago (in 1776) the great Scottish economist Adam Smith's The Wealth of Nations was published and for many, it has been the cornerstone in the development of Economics. Apart of the famous concept of the “invisible hand” and the division of labour advantages, the main focus of the text is on the economic history of nations. Including a very significant exposition on taxes in the chapter headed, “Of the sources of the general or public revenue of the society” (Book V, Ch 2).To quote:“All nations have endeavoured to the best of their judgement, to render their taxes as equal as they could contrive; as certain, as convenient to the contributor, both in the time and in the mode of payment, and in proportion to the revenue which they brought to the prince, as little burdensome to the people.” The above comments follow on from four stated axioms, or maxims (accepted truths), that should be present in all efficient tax systems. Precisely these are:

  1. equality
  2. certainty
  3. convenience of payment; and
  4. economy in collection.These are discussed in turn below.

 

  • Equality: Taxpayers should pay tax in proportion to their respective abilities to pay tax, i.e. in proportion to their relative earnings.
  • Certainty: It needs to be clear as to the amount of tax that needs to be paid, the timing of the payment and the manner of the payment. Uncertainty leads to corruption. In Adam Smith's eyes, uncertainty was a far worse evil than inequality in the burden of tax.
  • Convenience of payment: Tax ought to be levied at a time which is most likely to be convenient to the tax payer. In this sense taxes on consumables (i.e. indirect tax, such as value added tax) are a convenient tax for the consumer (and may be argued to be convenient to the supplier since he has earned the revenue from that sale to pay the tax).
  • Economy in collection. The cost of raising taxes should be minimised.

Adam Smith made a number of observations as to factors that affect such costs:

  1. The number of tax officers and their pay needs to be proportionate.
  2. The levying and assessing of taxes can divert the attention of businesses from dealing with their day-to-day commercial activities, which can benefit the nation far more by increasing employment and output.
  3. Penalties and forfeitures for the non-payment of tax may ruin an individual who might otherwise have used his capital to the benefit of the community and increased employment. Great care therefore needs to be exercised by government to avoid exacerbating difficult financial situations of taxpayers to the long-term detriment of society.
  4. Frequent visits and “odious” examinations by tax officers may expose taxpayers to “much unnecessary trouble, vexation, and oppression”. Although it is not possible always to measure the cost of excessive acts it can be psychologically damaging to the taxpayer as well as a waste of his, and indeed the government's, time and resources, leading to diversions damaging to the economy.

Inter alia, the calls for corporate organizations to pay their fair share of taxes, the desire for clarity as well as for certainty in modern tax regimes, and the move towards online submissions and payments, it can be seen that these concepts are as relevant today as they were 240 years ago.