Chapter 2: Tax Principles

Principles for a Well-Designed Tax System

In ESSB 6153, the Committee was directed to evaluate the existing state tax system
and to develop multiple alternatives guided by several principles or criteria for a well-
designed tax system. The Committee used the following commonly-accepted
working definitions for these principles in its determinations.

Commonly-Accepted Definitions

Adequacy/Stability/Elasticity. A good tax system is expected to generate sufficient

revenue to pay for established public services without the need for continuous or
drastic changes in tax rates or in the tax base.

• Adequacy is the ability of the tax system to provide for growth in revenue
adequate to fund normal growth in public services as the state’s population and
economy expand. Long-run elasticity (LRE) is a measure of that adequacy. A tax
system that has an LRE equal to 1.0 generates revenue growth commensurate
with the growth rate of the overall economy. If a tax system has an LRE that is
significantly less than 1.0, revenue will grow at a lower rate than the overall
economy, posing adequacy problems.

• Stability is the ability of the tax system to provide the revenue necessary to
maintain public services notwithstanding fluctuations in economic activity over
the business cycle. The short-run elasticity (SRE) is a measure of the stability of
the tax system. A tax system of normal stability has an SRE equal to 1.0 and
generates short-run fluctuations in revenue comparable in magnitude to
contemporaneous fluctuations in economic activity. A more stable tax system has
an SRE that is less than 1.0 and will generate fluctuations in revenue that are
smaller than contemporaneous fluctuations in economic activity. The converse is
true for a less stable tax system with an SRE greater than 1.0.

Equity/Fairness. A good tax system should distribute the tax burden across
taxpayers in a manner that is consistent with the accepted norms of fairness and
equity. These norms typically define fairness according to the relationship between
the amount of taxes paid (or borne) by taxpayers and their respective abilities to pay
the tax, or to the benefits received by them from government programs. Three
widely-accepted norms of fairness considered by the Committee are:

• Vertical Equity. This principle of fairness requires that the amount of tax paid by
taxpayers with different income levels should reflect their respective abilities to

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 pay the tax. Specifically, taxes paid as a percentage of income should not unduly
burden taxpayers with limited ability to pay the tax. Some would view this
principle as satisfied by a proportional tax burden, where taxes paid are the same
percentage of income for taxpayers at all income levels. Others believe that the
principle requires that taxes paid as a percentage of income should be higher for
taxpayers with more income than those with less income (a progressive tax
burden). To our knowledge, almost no one believes that taxes paid should be a
higher percentage of income for less affluent taxpayers than for those with more
income (a regressive tax burden).

• Benefits Received. A tax may be considered fair if the taxes paid are matched by
benefits received by a taxpayer from the government. This principle is most
relevant when a tax is levied specifically for the purpose of providing a particular
government service to a specific group of taxpayers. Such “benefit taxes” are
impractical for much of government spending because the “benefits” received
cannot be determined for each taxpayer. Therefore, this principle is relevant
mainly for certain types of selective excise taxes which act like user fees, such as
the motor vehicle fuel tax. It also applies to taxes that have much in common
with insurance premiums, such as employment security and industrial insurance
taxes.

• Horizontal Equity. According to this principle, taxpayers with similar abilities to

pay a tax should pay comparable amounts of the tax. More generally, the
principle of horizontal equity enjoins the government from levying taxes that have
arbitrary and peculiar distributions of tax burdens across taxpayers or from
levying dissimilar tax burdens on taxpayers that are not justified by differences in
their ability to pay or by distinctions in the benefits they receive from government
programs.

Economic Vitality and Harmony with Other States. A good tax system should not
place business enterprises located within the state at a competitive disadvantage
relative to similar enterprises located in other states. At a minimum, this requires the
following:

• The state tax system should not unduly burden enterprises located or considering
locating within the state of Washington relative to the business tax systems of
other states that offer a comparable non-tax business environment.

• The state tax system should be harmonized with those of other states in order to
prevent, or provide relief from, double or multiple levels of taxation on the same
economic activity. Similarly, the tax system should minimize the opportunities
for selective tax avoidance that would allow some firms to shift their taxable
activity out of the state and thereby raise the tax burdens on other firms within the
state.

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• The state tax system should support a stable economic infrastructure conducive to
a vital and growing economy. It should not subject the state economy to fiscal
crises that create a climate of fiscal and economic uncertainty.

Economic Neutrality and Efficiency. A good tax system should not distort
economic decisions. Distortions cause a measurable loss in the economic value of
production and consumption, which increases the tax burden on the residents of the
state. There are two important methods for minimizing the burden on state residents
of raising a given amount of state tax revenue:

• Different production and consumption activities should be subject to the same

effective rate of tax. Such a neutral tax system is efficient when taxpayers make
decisions based on economic advantages rather than tax advantages.

• The state should minimize the tax burden on state taxpayers by choosing a tax
system that maximizes the extent to which taxes can be exported (paid by
nonresidents). An example of exporting is facilitating Washington taxpayers’
abilities to take full advantage of deducting state and local taxes on their federal
income tax returns. This deductibility allows the taxpayers to shift part of their
state and local tax burden to the federal government by reducing federal taxes
paid.

Transparency and Administrative Simplicity. People should know when they pay
taxes and how much they pay. A good tax system is designed to ensure that the tax
burdens on residents are clear and evident. The rules, record-keeping and
computation requirements should be simple enough that the tax system can be
administered at low cost by the tax collection agency without imposing an undue
compliance burden on the taxpayer.

Home Ownership. The tax system should facilitate, or at least not impede, the
ability of individuals and families to purchase and maintain a home consistent with
their standard of living.

Interaction of Principles

The Committee recognized that in certain instances the advancement of some

principles may conflict with the maintenance or advancement of others. In other
cases, the advancement of several principles may be complementary. The
possibilities of conflict include:

• Exempting necessities from taxation may increase fairness but reduce neutrality.
For example, the exemption for groceries under the retail sales tax (RST) reduces
the neutrality of the tax and induces households to purchase more of the exempted
categories of goods. However, because low-income households spend
disproportionately more on necessities, these exemptions reduce the regressivity
of the RST, and therefore serve to advance vertical equity.

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• A tax that collects regular amounts of revenue regardless of fluctuations in
economic activity increases fiscal stability but imposes a steady burden on
taxpayers at times when they are less able to bear them. Such taxes are also pro-
cyclical (i.e., they exacerbate the state business cycle). On the other hand, a tax
for which revenue fluctuates more than economic activity increases the chance of
a fiscal crisis, yet it is counter-cyclical and acts as an economic stabilizer.

• The vertical equity principle may conflict with the benefit principle of fairness,
such as in the case of motor fuel and cigarette excise taxes. Although such excise
taxes may be justified by the transportation and health benefits received by the
taxpayer, they increase the regressivity of the tax system and burden lower-
income people disproportionately.

• Actively promoting home ownership requires a non-neutral tax structure.

Whereas a neutral tax structure treats all forms of consumption alike, including
housing services (whether rented or owned), promoting home ownership would
require a preferential treatment for expenditures on owner-occupied housing.

Given the potential conflicts among the principles, the Committee sought tax
structure alternatives that could balance competing objectives and, where possible,
take advantage of complementarities among the principles. The primary areas where
the Committee found complementarities are as follows:

• Broad-based, uniform taxes with fewer exemptions can advance the principles of
adequacy, stability, neutrality, and horizontal equity. The broader the tax base,
the greater the tendency for revenue to grow and fluctuate in concurrence with
overall economic activity. Also, a uniform tax rate structure treats different
taxpayers even-handedly while minimizing the distorting impact of taxation on
taxpayer decisions.

• A more transparent tax structure may be complementary to increased

competitiveness. A major cause of non-transparency occurs when taxes levied on
businesses are passed on to consumers in the form of higher prices—the so-called
“hidden” taxes. When business taxes cannot be passed on, competitiveness is
reduced. Increasing the fraction of taxes levied on households relative to taxes
levied on businesses makes the tax system both more transparent and more
competitive.

Taxpayer Perceptions and Considerations

Although the principles defined above represent a consensus of most tax experts
about good tax system design, the perceptions of ordinary taxpayers as revealed by
surveys and by studies conducted by behavioral scientists may operate in addition to,
or in some instances in opposition to, these principles.

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In this regard, two questions especially concerned the Committee.

• In addition to the principles enunciated above, what factors might influence

taxpayer perceptions as to the fairness of a particular tax relative to another?

• What factors influence taxpayer perceptions as to how burdensome a tax is

relative to the objective burden as measured by the revenue collected?

In the Committee’s investigation of these matters, the following observations were

made:

• Taxpayers seem to be unusually averse to “lumpy” taxes (a tax paid all at once is
“lumpy”). Unexpected lumpy taxes are the least popular.

• Taxpayers may be more resistant to taxes that are transparent than to taxes that are
hidden in the prices of the goods they buy. Thus, the principle of transparency
may conflict with the political feasibility of certain tax reforms because the
replacement of hidden taxes with transparent taxes may be perceived as an overall
tax increase.

• Taxpayers prefer taxes they think they can control through their own actions, such
as taxes on discretionary purchases. This preference conflicts with the principle
of neutrality, which ranks as superior a tax system that minimizes such taxpayer
control.

• Surveys in other states have found that many taxpayers list the retail sales tax as
the “most fair” because everyone pays the same rate of tax. However, sales taxes
are regressive because low-income taxpayers spend a larger portion of their
incomes than do high-income taxpayers. Thus a tax that is perceived as fair in
one respect is considered unfair according to the principle of vertical equity.

• People dislike taxes to which they are not accustomed.

• Taxpayers have a sense of “reciprocity.” Hence, they are less resistant to ear-
marked taxes where they perceive the benefit of a tied government service.
Another example of reciprocity is that people are more likely to comply with a tax
when they perceive that other taxpayers comply.

While taxpayer perceptions should not take priority over the accepted principles of
good tax system design, it is wise to take note of them when evaluating the existing
tax system and any potential alternatives. The operative principle here was best
expressed by Abraham Lincoln who said, “A universal feeling, whether well or ill-
founded, cannot be safely disregarded.” Also, discrepancies between taxpayer
perceptions and the principles of good tax design identify issues on which it is
particularly important to inform and educate voters about the objectives of proposed
reforms.