Introduction

Employment income generates the lion's share of revenues from the individual income tax, particularly in developing and transition countries. The task of collecting tax on employment income is simplified by the fact that the source of employement income is generally easy to identify. If each employee had one job with a steady wage and no other income sources, the issue of collecting employee income tax in a final form could be solved through imposing a withholding obligation on the employer. However, if an employee has several jobs, or has other income, or his or her wage varies from month to month, it may be necessary for an income tax return to be filed. The number of returns in developing and transition countries should generally be kept to a minimum, as processing individual tax returns requires scarce human and material resources on the part of the tax authorities.

Collecting employee income taxes involves striking a balance between fairness with respect to the taxpayers, collecting all due taxes, and avoiding an excessive burden on tax authority resources.

Withholding Methods

Virtually all of the countries in the world collect employee income taxes on a current basis by way of withholding by the employer. This is often called the pay-as-you-earn (PAYE) system.¹

There are three basic methods for applying a PAYE system:

1. Simple PAYE:

Under this system a monthly withholding table is established by the tax authority with respect to different brackets of monthly wages. The tax paid is not adjusted for wage changes during the tax year - any difference between the amount withheld and the total income tax due for the year is accepted as the price for the simplicity of the system or resolved by filing a tax return at year-end. In this system the payment of substantial non-periodic wage income may cause difficulties.²

2. Cumulative PAYE:

In the cumulative PAYE system the total income tax liability of the employee is recomputed each pay period in order to make the tax withholding as close as possible to the total income tax obligation. If there is a change in the monthly wage, the total income tax liability is recalculated and the difference between the new total income tax liability with respect to cumulative wages and the tax already paid is withheld in the given month.³

3. Year-End-Adjusted PAYE

Under the year-end-adjusted PAYE system, monthly withholding is carried out as under the simple PAYE system. At the end of the year, however, the final withholding is calculated taking into account the total income tax liability (i.e. a year-end adjustment is made if there is a difference between the total tax withheld and the total income tax liability).⁴

Finality of PAYE

As mentioned above, withholding does not necessarily represent the final tax payment for the employee. There are three broad degrees of finality for PAYE:

• Preliminary PAYE

In countries that use a preliminary PAYE system, even though income tax is withheld on wages earned, all taxpayers file tax returns (whether or not they have other income). This is typically seen in countries with highly computerized tax administrations, globalized systems, and numerous special allowances and credits (which are often refundable).⁵

• Semifinal PAYE

Semifinal PAYE is the most common approach countries take. In a semifinal PAYE system, employees that have wages from only one source generally do not have to file a tax return. If the employee has a second job, tax is paid with respect to it by way of withholding by the second employer. Return filing may be required when other income surpasses a certain minimum threshold.⁶

• Final PAYE

Under the final PAYE system, the tax withheld from wages is generally considered to be the final liability of the employee. Some systems may be somewhat short of final, in the sense that some employees may be required or permitted to file a return.⁷

Fashioning a Solution

In designing a PAYE system, the costs of alternative taxing systems should be estimated, including both private sector compliance costs and costs to the tax administration.

In developing and transition countries, tax administrations may not have the resources (both human and financial) to properly process a large number of tax returns. Thus, in these countries the focus should be on limiting to the extent possible the number of tax returns filed. Furthermore, employers, especially smaller companies, may not have the sophistication required to make complicated tax calculations. Under such circumstances, a relatively simple and final PAYE system may be considered where for the majority of employees the final tax obligation would be met through withholding and only a few taxpayers would have to file returns. For taxpayers having other income, a threshold could be established above which a return is required to be filed. In establishing this threshold, the ability of the tax administration to process returns should be considered. Under this system the tax administration would only have to concentrate on monitoring the withholding carried out by the employers and assessing a small number of additional individual tax returns.

A simple and final PAYE generally works only if the overall income tax policy involves marginal rates that are not steeply progressive and does not involve a large number of allowances and deductions for individuals. Many developing and transition countries are following such a policy. In such a policy context, a simple withholding system can be enforced relatively easily and at a low cost from a tax administration point of view. By contrast, a more sophisticated and arguably more equitable system may not be enforceable in countries where tax administrations lack the necessary means and experience.⁸ This is an important reason why such countries typically choose to keep their tax policy simple.

For further reference:

Koonraad van der Heeden, The Pay-As-You-Earn Tax on Wages, in 2 Tax Law Design and Drafting 564 (1998).

IMF Legal Department, Tax Law Note: How Should Tax be Withheld on Fringe Benefits?