The government imposes taxes and they create burdens to taxpayers. However, the same taxes are used for the welfare of all citizens. This means that taxes have both good and bad effects. An optimum or a good tax system is defined as one, which helps to achieve the maximum possible number of principles of taxation. Adam Smith was the first economist who laid down the first four important Canons of taxation.
1. Canon of Equity
The principle aims at providing economic and social justice to the people. According to this principle, every person should pay to the government depending upon his ability to pay. The rich class people should pay higher taxes to the government, because without the protection of the government authorities (Police, Defence, etc.) they could not have earned and enjoyed their income. Adam Smith argued that the taxes should be proportional to income, i.e., citizens should pay the taxes in proportion to the revenue which they respectively enjoy under the protection of the state.
2. Canon of Certainty
According to Adam Smith, the tax which an individual has to pay should be certain, not arbitrary. The tax payer should know in advance how much tax he has to pay, at what time he has to pay the tax, and in what form the tax is to be paid to the government. In other words, every tax should satisfy the canon of certainty. At the same time a good tax system also ensures that the government is also certain about the amount that will be collected by way of tax.
3. Canon of Convenience
The mode and timing of tax payment should be as far as possible, convenient to the tax payers. For example, VAT is collected when people have means to spend; income tax e.g PAYE is deducted at source. Convenient tax system will encourage people to pay tax and will increase tax revenue.
4. Canon of Economy
A good tax should be economical in two ways;
a) This principle states that there should be economy in tax administration. The cost of tax collection should be lower than the amount of tax collected. It may not serve any purpose, if the taxes imposed are widespread but are difficult to administer. Therefore, it would make no sense to impose certain taxes, if it is difficult to administer.
b) A tax should be economical to the taxpayer i.e. a taxpayer should afford to pay all the taxes levied on him and afterwards have sufficient cash left with him to cater for his consumption, savings and investment needs. Heavy taxes discourage saving and investment and end up undermining the productive capacity of a person.
Additional Canons of Taxation
Activities and functions of the government have increased significantly since Adam Smith’s time. Governments are expected to maintain economic stability, full employment, reduce income inequality & promote growth and development. Tax system should be such that it meets the requirements of growing state activities. Accordingly, modern economists gave following additional canons of taxation.
5. Canon of Productivity
It is also known as the canon of fiscal adequacy. According to this principle, the tax system should be able to yield enough revenue for the treasury and the government should have no need to resort to deficit financing. This is a good principle to follow in a developing economy.
6. Canon of Elasticity
According to this canon, every tax imposed by the government should be elastic in nature. In other words, the income from tax should be capable of increasing or decreasing according to the requirement of the country. For example, if the government needs more income at time of crisis, the tax should be capable of yielding more income through increase in its rate.
7. Canon of Flexibility
It should be easily possible for the authorities to revise the tax structure both with respect to its coverage and rates, to suit the changing requirements of the economy. With changing time and conditions the tax system needs to be changed without much difficulty. The tax system must be flexible and not rigid.
8. Canon of Simplicity
The tax system should not be complicated. That makes it difficult to understand and administer and results in problems of interpretation and disputes.
9. Canon of Diversity
This principle states that the government should collect taxes from different sources rather than concentrating on a single source of tax. It is not advisable for the government to depend upon a single source of tax, it may result in inequity to the certain section of the society; uncertainty for the government to raise funds. If the tax revenue comes from diversified source, then any reduction in tax revenue on account of any one cause is bound to be small.