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Touching on an analytical framework and criteria is very important to choosing the best option whether the law makers should increase or decrease the marginal tax rates. In order to answer this question, Meade (1978) pointed out that we need to have in our minds main desirable characteristics of a tax structure as economic efficiency, distributional aspects, international aspects, flexibility and stability, transitional problems, and simplicity and cost of administrative compliance. Alm (1996) suggested a systematic way to start to analyze by emphasizing that analysis of taxation requires balancing the trade-offs between equity, efficiency, and revenue-yield and while designing tax system. As any decision for tax rates is surely a choice among alternatives, this choice affects the distribution of tax burden on individuals (equity), and the net yield of tax collection after subtracting administrative and enforcement costs from gross tax revenues(revenue-yield), and leads to change in decisions and behavioral responses of individuals and firms (efficiency), (Alm, 1996, p.125). One tax system can be defined as more efficient than another if it can raise the same amount of revenue with a smaller loss of welfare across the society as a whole. Harberger (1964) addressed that this kind of distortions induced by taxes in economic decisions lead an additional cost to taxpayers and society and reduce social welfare. However economic analysis of tax systems traditionally focuses on efficiency and equity. (Mirrlees et al., 2010).
Lowering marginal tax rates would increase social welfare through various channels affecting consumption, savings, labor supply. Widmalm (2001) found that different taxes have different growth effects and that tax progressivity is negatively correlated with growth.
Firstly, as related to labor supply the directions of tax impacts are opposing “substitution” and “income” effects. Any rise in the income tax rate lowers the price of leisure relative to work and creates substitution effect by discouraging work (Leibfritrz et al., 1997). At the same time, higher income tax rates reduce the disposable income of workers and leads income effect by increasing work effort to compensate income loss.
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Secondly, Reducing marginal tax rates would also stimulate savings because marginal propensity to save increases as income increases. Any reduction in tax rates for high-income taxpayers would increase savings. Thus, that would increase economic growth and social welfare because economic growth rate in the long-run is mainly determined by the level of savings rate (Solow, 1956).
Additionally, under the free flow of capital, international tax competition does matter for investors to increase their after-tax earnings as well as for countries to attract investments in order to create new jobs and to achieve higher economic growth rates. Lowering marginal tax rates will provide a favorable investment climate for investors and small businesses and enhance entrepreneurial Activities.