The economic effects of taxation can be studied under heads. They are:
- Production
- Distribution
- Inflation
- Depression
- Consumption
- Employment
According to Dalton, “The best taxation from economic point of view is that which has best or the least bad economic effects”
While the classical economists considered tax as a source of revenue only, modern economists regarded it as an important tool for achieving socio-economic objectives.
The main objectives of a taxation system is to regulate the economy. This is achieved by maintaining stability in the economy through proper control over production, distribution, consumption and employment in an economy.
Economic effects of taxation on Production
This can be studies under three sub heads –
(1) Effect on the capacity to work, save and invest
The purchasing power of people reduces when they pay tax and hence it also reduces their consumption. This reduces their overall efficiency to work.
Thus, taxes must aim to increase a person’s ability to work and save, therefore, certain taxes such as taxes on liquor and tobacco are necessary, as they improve a person’s health but taxes on necessities are undesirable as necessities are essential for survival. This also suggests that people with low income must not be subjected to tax as it will have a negative effect on their ability to work and save.
A person’s capacity to invest depends upon the resources available with him i.e. savings. Since tax reduces the income of a person, he will be able to save less and hence his capacity to invest also decreases.
(2) Effect on desire (will) to work, save & invest
As taxes effect the capacity of person to work, save and invest, a person may be motivated to work more or demotivated to work less on the basis of nature of tax imposed on him.
The effect of tax on desire to work, save & invest can be understood by the following two factors:
(a) Psychological reactions of tax payer due to income elasticity of demand.
- If income elasticity of demand is inelastic – A person will work more and earn more to meet his requirements.
- If it is elastic – A person may not work hard to increase his income.
- If it is unity – The desire to work remains the same irrespective of imposition of tax
(b) Nature of tax
While a progressive tax on income may result is negative effect on the will of a person to work, save & invest, taxes on casual income of a person, inherited property or additional taxes during war do not effect a person’s will to work.
(3) Effect on distribution of economic resources
Production of a country is directly dependent on the amount of resources allocated to different sectors, industries, regions etc. of an economy.
Some economic effects of taxation w.r.t distribution of economic resources:
Taxes on intoxicants will discourage its production and consumption. These resources may be diverted for production of essential commodities. Hence, such a tax is desirable.
Taxes on necessities will discourage a person as it will increase the cost of living. Such tax may divert resources towards production of useless products. Hence, it is undesirable.
If taxes encourage savings and discourages consumption it diverts resources from present to future. If taxes discourage savings and encourage consumption, it results in diversion of resources from future to present.
Resources are also diverted from the state where tax burden is heavy to a state where tax burden is light.
Economic effects of taxation on Distribution
Taxation effects the distribution of income and wealth amongst different sections of the society depending upon (a) the nature of tax and tax rate (b) kind of tax
(a) The nature of tax and tax rate
- Under progressive taxation – The rich bear more burden of taxation than lower income people. Thus inequalities in distribution of income and wealth is less or reduces with time.
- Under proportional tax – Inequalities increase with un-proportional increase in income of individuals and remains the same if income of individuals remain the same.
- Under regressive taxation – Inequalities increase as more tax burden is borne by the poor and less by the rich.
(b) Kind of taxes
- Direct taxes such as income tax are progressive in nature, therefore, the burden of tax lies more on the rich and less on the poor.
- Indirect taxes are regressive in nature, therefore, the burden of tax lies more on the poor and less on the rich.
Taxation and Inflation
Taxes help in reducing the demand for goods and services by restricting the purchasing power of the public thereby keeps a check on inflation. It helps to fill the gap between demand & supply as subsidies provided by government in form of tax benefits will help producers to produce more and taxes charged by public will reduce their demand.
Taxation and Depression
By adjusting taxes both marginal propensity to consume and amount of investment can be increased (by discouraging savings) which helps in curbing depression.
Taxation and Consumption
While taxes on intoxicants is desirable, taxes on necessities are undesirable. Thus high taxes can be imposed on unproductive activities & commodities to discourage its consumption and tax relief on necessities can be provided to increase its consumption.
Taxes and Employment
When more revenue is collected by the Government by way of taxes, it can be spent on social and welfare activities and hence increase production and employment.