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This is Part II of a 3 part essay on taxation and discusses considerations for taxation policy, and recommends what is IMO some good principles.

Part I provided some background on how taxes work in eRep today for the inexperienced reader.

Part III looks at import taxes on a more in-depth level, considering that these are the specific taxes under discussion at the moment.



CONSIDERATIONS FOR TAX POLICY

With the basics of taxation rules and black market operations under our belt, it’s time to think about what considerations should be discussed in setting tax rules.



1) MEETING BUDGET COMMITMENTS - Fairly obvious, but tax collection should be set at a level where the government can meet its budget commitments. Not enough tax revenue and government could run out of money to support the defence force or other commitments. Over-collection to build a large surplus puts a dampener on economic activity by pulling currency out of circulation. Tax revenue should be set at the point where revenue matches expenditure while maintaining a reasonable reserve to cover unexpected deficit spending. The complete lack of any macroeconomic tools makes this a very inexact science with a lot of guesswork, but a bit of experience allows fine-tuning to more or less accomplish this.



2) MINIMISING TAX AVOIDANCE - The higher the rate of tax, the higher the incentive for tax avoidance. For example if income tax is set at a relatively low level (say, 5😵 there is very little incentive to avoid it. As discussed earlier, there is some effort and risk involved in avoiding tax, so if the benefit is quite small (5% of salary in this example) it probably isn’t worth doing. However, if income tax is relatively high (say, 30😵 the incentive is far higher. This leads to the counter-intuitive result that increasing tax rates can actually lead to a reduction in tax revenue, as citizens use tax avoidance measures in greater numbers.



3) AVOIDING ADVERSE IMPACT ON THE ECONOMY - Each form of taxation has it’s own effect on citizen welfare and business profitability. Though it is over-simplistic to separate these 2 effects (as they have strong interdependence) I do it for the sake of understanding the broad effects.

- Income taxes reduce citizens’ disposable income and therefore demand, a negative effect on citizen welfare and business profitability

- VAT increases the prices of goods, a negative effect on citizen welfare and indirectly reduces demand, a negative effect on business profitability

- High import taxes discourage imports and therefore tend to reduce competition. As other countries can achieve higher production bonuses they are more productive than our 3rd world economy and can theoretically produce goods more cheaply subject to prevailing salary levels in their home country and exchange rates. Import taxes tend to increase the cost of imported goods and therefore not allow citizens to take advantage of lower prices, a negative effect on welfare. Import taxes do have a positive effect on business profitability in the sense that local producers do not have to compete with importers and can therefore set higher prices.



SUMMARY - GOOD TAX POLICY

Taking all of these considerations into account, let’s consider what makes good tax policy. As we’ve seen, high taxes in any area have direct and indirect negative effects on citizen welfare and business profitability with the exception of import taxes which can have a positive effect on business profitability. High taxes also tend to increase the incentive to spend additional time and effort avoiding tax (and accept the inherent risk of black market transactions), and in extreme cases increasing tax can lead to reduction in tax revenue.

This means that as a general rule a good tax policy is one where all taxes are applied at a moderate level without over reliance on any specific form of taxation. Over-reliance on a specific form of tax will mean it needs to be relatively high (or government revenue and expenditure will need to be relatively low) and will lead to tax avoidance. This implies a balanced application of all taxes, at the lowest level necessary to meet government expenditure needs. Given the lack of macroeconomic analysis tools this initially involves some guesswork, then fine-tuning.



That’s it for Part II of this 3 part series.

Part I provided some background on how taxes work in eRep today for the inexperienced reader.

Part III looks at import taxes on a more in-depth level, considering that these are the specific taxes under discussion at the moment.