11 Feb 2008

Tax Simplicity: Dimensions explored

Since I am aspiring to be a tax buff (you will know more about it soon enough with the post upon second month of this blog), I thought why not started with the simplest in tax; tax simplicity. More so ever when this issue is at the heart of the UK tax administration (formally; Her Majesty's Revenue and Customs or simply HMRC), there is a lot of literature available on the issue. The 'Tax Rewrite Project' in fact aims to rewrite the existing taxation laws of the country into a much simpler form (only in terms of language though) such that it is easier to understand and comply with (though its a different issue altogether that this has led to thickening of both the primary and secondary legislation after the re-write). In fact the issue of tax simplification is not just a lip service but has in fact come out with (as of date) four pieces of re-written legislation [click here for more details].

But then speaking simplicity is not sufficient unless we know simply know why we need simplicity and what it means. As Richard Baron, the Head of Taxation at the
Institute of Directors in his 'IoD policy papers on Tax Simplification' enumerates; tax simplification is required for;

  • Complexity absorbs resources: both at the level of the tax payer and the government as more and more resources are required for coping up and administrating the tax system. The increasing amount of resources being diverted to look for ways for tax planning is also a considerable reason for avoiding complexity in the tax legislation;
  • Complexity can cloud commercial decisions: this issue arises for while taxing decisions, the managements do give a lot of consideration to the tax implication of the situations and the ways to figure them out instead of simply going by the idea of taking decisions which increase the efficiency and effectivity with which they operate;
  • Complexity makes the country less attractive: and rightly so for in this global era of capital mobility and investment flows, most companies and investors find it preferable to carry out their operations in a friendlier scale and more much in a tax haven;
  • Complexity can make compliance harder: as it requires more and more considerations to be weighted while individuals and corporates find ways and means to reduce their tax liabilities and also try to fit in the system, filling out the details required to stay on the right side of law.

Expanding more of his thought and relying upon previous research, he seeks to classify the types of complexity in three types; policy complexity (i.e. one arising out of the intentions behind framing tax rules the way they are); drafting complexity (i.e. one arising on account of the wording of the rules in which they are framed); and application complexity (i.e. one arising because of the way in which the tax rules are sought to be applied in the system).

As for the causes of the complexity, they are identified as follows;

  • commercial causes: these essentially are attributable to the ways businesses have advanced in the modern day and the manner in which transactions take place in the present era. Since the mechanisms have advanced; consequently, the tax systems have to rise up to the ever challenging task of taxing a fair share for the government revenue as it is the government which provides the businesses the means and resources for them to function in this diabolically unstable and changing world;
  • policy causes: which arise because the governments compete to meet certain objectives, especially those attributable to the notion of welfare status, such as those relating to reducing inequalities of income and wealth, categorization of products and services to be taxed and once meant to be promoted by exempting them from the tax jurisdictions, etc. Further the constant and rising usage of tax systems by the governments for the promotion of social objectives (such as those related to changing social behavioural patterns, for example smoking of cigarettes, etc.) have also led the tax systems to be crumbled with plethora of rules which though meant to achieve certain novel objectives, simply render the system complex and unworkable;
  • the system of policy-making and legislation: this is really an interesting but important reason as a large number of times when the tax rules come out to be complex, the reason behind they being such is the unequipped understanding of the policy framers as to what they want to achieve and the decision they take as regards the means by which they they want seek to achieve it. The ill-understanding of the objectives sought to be achieved and the way in which society reacts to the changes in the tax system can sometimes lead to a series of rectifying rules (called amendments) and when these are inter-mingled with anti-avoidance rules, they simply create havoc in the system.

But then this policy paper taxes an interesting term. It relates us back to a situation of eye for an eye and tooth for a tooth. This is for the reason that it is suggested that tax simplicity cannot be achieved unless there are trade-offs i.e. the government willing to undergo a couple of the basic tenets of tax policy (just to add a bit of qualification here: over time most modern features in tax policy have come to be treated as the basic tenets).

The first trade-off suggested in the line is one between simplicity and policy objectives. To quote, “Any government has a choice between four broad approaches to special tax measures to encourage or discourage particular behaviours;

  • It can set detailed objectives and devise measures to achieve them precisely.
  • It can set detailed objectives but then devise measures that may only achieve them approximately.
  • It can set broader objectives and devise measures to achieve them.
  • It can forswear the use of the tax system to promote specific behaviours and use the system simply to raise money, with the burden distributed in an acceptable way.

The first approach might seem to be best in theory, but it is likely to fail. This is because people do not respond precisely as hoped to the implicit signals given by the tax system. The only exception is sophisticated financial markets, where a tax measure can change the profitability of a given financial instrument by a precise amount and the market will respond accordingly. Therefore a government might as well content itself with the second approach. At that point, one has to ask whether it is worth trying to achieve detailed objectives that may well only be approximately achieved, in which case the third approach may be just as good. This has the advantage that the measures devised are likely to be a good deal simpler than those which would be devised under the first or second approaches. Finally, the fourth approach is the one most likely to promote a simple tax system."

It is therefore clear that how far a tax system would be rendered to be simpler is actually the sweet prerogative of the government and it may as well decide at odds to reduce the complexity provided it is willing enough to do so.

The second trade-off brought to light is one which calls for doing away with existing special relief and changes in lieu for a simpler tax system. To put it simply what is suggested in the paper; it is argued that by doing away with the special rules giving exemption and relief or imposing special liabilities, it is better to fiddle with the basic tax rates and increase (or decease, as the case may be) the income limits for amenability to taxation and thus provide a much simpler tax system to administer than one surrounded by a web of such complex rules and provisions.

The third trade-off, and really an interesting one, ponders over the issue of changing the type of law dealing with tax system altogether. But then giving it an afterthought, it looks really the reason for all the complexity in the tax legal system. It is argued that while the least number of cases in tax system are terribly complex and out of the ordinary, the maximum number of regulations and provisions are meant to curb the potential advantages that may be derived of them. The consequence, naturally, is that the provisions dealing with the simpler and less acute cases have to accommodate special rules in respect of such complex cases and this makes the system complex on a whole. In these circumstances, therefore, it is submitted that it would be better to have a principle-driven regime for dealing with cases rather than have a strictly-rule based regime (from which the underlying policy can hardly be deciphered out) such that cases can be dealt with accordingly at an easier pace and at an appropriate level. To this regard I would personally like to take the example of the German tax system which largely seems to follow a principle-based regime in tax system and is worth emulating.

The above being the general consideration in tax policy and simplification of the applied tax-systems, there arise special and specific concerns when it comes to individual cases. For example the ways to deal with simplification of income tax rules would differ considerably both in terms of approach as well as the scope for reform than a consumption tax. It would be too high and technical an analysis for the purpose of this blog and therefore I thought wise to simply rule out its discussion here, perhaps some other time.

But then, in a conclusive remark, it is worthwhile to point out that any approach of simplification of a tax system should be conducted on a two-fold basis; the first being to have an aim/objective approach i.e. starting by determining the aims and objectives of the simplification exercise and the second being the process-fixation approach i.e. determining the ways and means to achieve the aims and objectives set forth. Without the either of the two being taken in the correct perspective, the purpose would not be achieved and the attempt would be in vain to simply figure-out to make the system workable.

In case you are looking for further readings, I would be quick to point out the following (though all of them in-principle relate to the
United Kingdom approach to tax-simplification);

  1. HMRC's Tax Simplification Review for October 2007
  2. HMRC's Principle based approach to financial products avoidance
  3. HMRC's Tax Law Reform (2005-06)

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