There are limits to indirect taxes

There are limits to indirect taxes

Finance Minister Mehmet Şimşek recently announced that the year-end budgetary targets would not be realized. This was expected even before the miserable second-quarter growth figure was revealed. Although the minister reassured businesspeople later on, saying no extra tax was on his agenda, the opposite has generally been usual in Turkey, particularly when economic activities slacken and, as a result, tax revenues begin to drop.

It means that increases in the prices of some public goods and services, new taxes and/or an increase in tax rates next year might not be a surprise. However, at least Minister Şimşek was sincere, as he did not mention “tax reform” this time. It is good news because whenever a change has been made in taxation that was called “reform,” it brought only deformation to the existing system which has made Turkey a tax haven for some privileged people but a hell-like place for all others.

If it bears repeating, every textbook written on public finance begins to explain two very important taxation principles: “equality” and “justice.” This means an equal tax burden on equal incomes and a smaller tax burden for smaller incomes. In order to guarantee the implementation of these two principles during taxation, a progressive tariff (which means higher tax rates for higher incomes) is used and special care is given to the fact that the share of the revenues from direct taxes (i.e. personal and corporate income tax) must be much higher than the revenues from indirect taxes (i.e. value-added tax).

The reason is obvious. Indirect taxes are proportional and are levied at the same rate as all transactions whether the tax payer is rich or poor. On the contrary to those taxing principles, the share of indirect tax revenues in total has climbed during recent years to about 70 percent.

To finance a budget deficit through taxation and price increases in public goods and services is more reasonable than borrowing and printing money. However, when heavy indirect taxes begin to impact upon low-income people after they first cut their necessary daily consumption expenditures, they might decide at some point to use their limited savings before abandoning saving at all instead of sacrificing from their necessary consumption. This happened in some Western European countries after World War II when governments could not find any other way besides indirect taxation to finance public expenditures.

In short, taxation is a must for every modern society to finance necessary public expenditures. However, during taxation, special care must be given to the principles of equality and justice. Otherwise, the country in question easily becomes a tax haven which injures principles and cripples the targeted tax revenue.

There is a well-known tale in the Middle East. A cruel sultan used to increase taxes every year to finance every military campaign and build new palaces. He notices the sad faces of the poor people each time he raises the taxes, but he doesn’t care. However, one day after announcing a new tax for a new campaign, the same poor people begin to sing and dance, scaring the sultan as he realizes that he has crossed the limit. The moral of the story: There is a limit to levying new taxes and/or increasing rates. When this limit is exceeded, tax revenues begin to decrease instead of increase. In modern literature, it is called the Laffer curve effect, carrying the name of the economist who first observed this contradiction. Making a tax reform which changes a tax structure that depends mainly on direct taxes instead of indirect taxes requires political courage in every country, especially in developing ones. However, it is better to act courageously now instead of facing additional problems later in financing public expenditures.