By CPA Faustin Mwinzi
Timing and Manner of Taxation Should Encourage the Taxpayer to Pay
Toward the promulgation of Kenya’s 2010 constitution, all forces had conspired to usher in the supreme law. The country had just come out of its lowest moment, the 2008 political crisis. It was said that the country was in a constitutional moment and indeed we seized the moment and gave ourselves a new constitution.
I compare the political crisis back then to the tax situation we are in as a country. For the last two years, tax has been the most dominant topic in all debates, we have a huge fiscal deficit to fix, and our tax base is still narrow. The clamor for stability in tax policy is live, but tax laws are becoming even more uncertain. A draft National tax policy has been created but the debate still ranges. I see this crisis as a blessing in disguise, just as we had a constitutional moment in 2010, we have a tax reform moment.
There are some candid questions we must ask ourselves; must we pay taxes; the answer is obviously yes. Then the next set of questions would be, can taxes be fair to all? Can we bring all persons to the tax net? is it possible to have voluntary compliance? Are our taxes understandable to the taxpayers? Finally, will society be worse off or better off after paying taxes?
As we create tax policy and tax laws, we must get the above questions right by considering principles that have stood the test of time. Certain yardsticks have been proven relevant over time across all jurisdictions. These are maxims of taxation better referred to as canons of taxation, the word canon to imply decrees.
In his 1776 Magnum Opus, Wealth of Nations; Adam Smith, the father of modern Economics modeled an Ideal economic system, clearly demarcating the roles of the state and its subjects. He made strong arguments on individuals’ pursuit of self-interest and free trade through which individuals unknowingly promote the nation’s interest in what he called the invisible hand. That’s for another day, concerning taxation, Adam Smith advanced four canons that have reigned supreme over the decades.
The first Canon of taxation in Adam Smith’s writing is the canon of Equity, which can be loosely interpreted to mean fairness or the principle of ability to pay. Adam Smith says, “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state”.
This statement justifies progressive taxes where the rich pay more than the poor. That’s natural because of their respective abilities, but more to it is that the rich derive more revenue under the protection of the state than the poor. A chapter before these canons, Adam Smith discusses the critical roles of the state function of defending its subjects. The rich derive more protection from the state and other functions; therefore, it is right to ask them to pay more.
Equity implies neutrality in taxation. The economic choices of individuals should not be influenced by taxation. For instance, a decision to be under formal employment or self-employment either way taxes should remain the same. In other words, Equity in a tax system means the playing ground should not be tilted against any economic player. It’s controversial that taxes do not discriminate incomes from illegal sources, if they did crime would even be more attractive.
Level playing ground implies two things, taxes must be designed to have wide coverage such that there are no economic sectors left out. The second aspect is on enforcement of the written laws, there should be slight chink for tax evasion. Tax evasion is a double punishment for patriotic taxpayers in the sense that they are left to carry a heavier burden that would have been shared with the evaders, secondly, the evaders get an unfair competitive edge in the market.
The argument of equity has far-reaching implications, even in international trade. Why would a country tax its residents on their foreign incomes? It is because they derive protection from the state in the country of residence. Yet again why would a foreigner be taxed on income earned in a foreign country? Of course, they needed protection from that foreign government to derive their income. Neutrality comes in the design of international tax laws to ensure that there should be no tax advantage created under cross-border activities.
Equity in taxation is so supreme that it is enshrined in Kenya’s 2010 constitution. Article 201 (b) i. states “The burden of taxation shall be shared fairly”. This clause was invoked against the minimum tax that had been passed into law by the Finance Act 2020. This tax was proposed at 1% of gross revenue regardless of whether businesses were making profits or losses. In quashing this piece of legislation, the high court held it is unconstitutional to require loss-making entities to pay taxes out of capital while ordinarily businesses pay taxes out of profits. (Refer to Kitengela Bar Owners Association v National Assembly)
The second canon of taxation according to Adam Smith is the canon of certainty. The tax which an individual ought to pay should be certain and not arbitrary. The manner, mode, timing, and amount of tax payable should be predetermined by law and made clear to the taxpayer and any other person. Uncertainty breeds corruption which Adam Smith explains as follows “The uncertainty of taxation encourages the insolence, and favors the corruption, ofan order of men who are naturally unpopular, even where they are neither insolent nor corrupt”.
The third canon of taxation is convenience. The timing and manner of taxation should encourage the taxpayer to pay. Pay as you earn is collected through the employers, that’s the most convenient way of taxing employees, same with all withholding taxes. Value-added tax and other indirect taxes are collected from the consumers when they have the means to spend. These indirect taxes are so convenient to the consumer in the sense that they are paid in little-by-little bits, again they can be avoided altogether by avoiding the products. That’s the case with luxury products.
The fourth Canon is the Canon of Economy. According to Adam Smith, “Every tax ought to be so contrived, as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state”
Jean Baptiste Cobalt had a better of explaining it, he says “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing”. In other words, economy in taxation is a tight balancing act between maximizing the revenue yield of the state while minimizing the adverse effects befalling the taxpayers.
Economy in taxation addresses two issues, affordability of taxes by the taxpayers and secondly costs of taxation. There are fundamental issues to raise here lest taxes become counterproductive and eventually ruin the country they were meant to build.
Affordability means that, upon payment, the taxpayers should be left with sufficient resources to allow them to participate in their economic duties of consumption and production. Less disposable income will mean poor consumption habits and consequently a sickly nation. You would rather have a healthy nation than more hospitals.
Heavy taxes impair the ability to save and invest. To quote Adam Smith “it may obstruct the industry of the people, and discourage them from applying to certain branches of business which might give maintenance and employment to great multitudes. That takes us back to Adams Smith’s initial premise on the invisible hand through which private entities promote the interests of the Nation like employment.
The second facet of economy in taxation is the costs of taxation. There are three costs of taxation namely administration costs, compliance costs, and thirdly tax evasion costs. Administration costs refer to the costs incurred by the government in tax collection, simply the costs of running the Kenya Revenue Authority. The revenue yield from taxes must outweigh the costs of collection, it is a cost-benefit argument. This may be obvious when we consider all revenue against all costs, but every single tax must be checked through this lens.
Compliance costs are the costs incurred by taxpayers in the process of paying taxes. This takes the form of employees hired to manage a tax department in an organization, the cost of tax consultancy, training, and software to enhance compliance. Compliance costs increase the effective tax rate; thus, taxes might be far too expensive than the nominal rates stated by the government.
Adam Smith would say this on compliance costs “By subjecting the people to the frequent visits and the odious examination of the tax-gatherers, it may expose them to much unnecessary trouble, vexation, and oppression; and though vexation is not, strictly speaking, expense, it is certainly equivalent to the expense at which every man would be willing to redeem himself from it”
Compliance cost is part of the dead weight costs of taxation which the government should aim at eliminating. The cure to this cost is simplicity in taxation. Two key areas require to be simplified, the tax laws to make them comprehensible to the common reader. Secondly and most important is simplicity in the enabling technology. It is important to pause here and judge E-Tims, on the intention versus the achievement.
The last cost of taxation is the evasion cost. These are the losses that accrue to society out of unsuccessful attempts by some taxpayers to evade taxes. Invariably some businesses become casualties of tax evasion, and end up closing shop. That loss extends to their employees, suppliers and many other economic units directly or indirectly connected to them.
In dealing with tax evasion the government should be more proactive with preventive measures rather than reactive punitive measures. Punishing tax evaders not only ruins the evader but puts to an end the benefit that the society could have received from the employment of their capital.
There are other principles of taxation opined by modern economists, however, they find their roots in these four classic canons. As a country, we anticipate more and more changes in taxation; the 1776 writings still provide a faultless weighing scale for evaluating our options.
CPA Faustin Mwinzi – Director KCA University
Professional and Technical Training Institute
