Economic Effects of Taxation

Taxes are defined as the basic source of revenue for the government and can be described as the money that people are required to pay to the government, and government deploys these inflows in public service and helps the economy move at a pace. It is a burden laid upon the citizens for the income they earn or the assets they hold, tax is not a voluntary contribution to fund public service rather it is an enforced contribution directed by law. Taxation is levied by government bodies to incur common welfare expenses for society and to meet expenses related to Defense, Medical infrastructure, Road connectivity, Education, etc. It is the Indian constitution from which the government derives power to levy and collect taxes. Moreover, taxes can be of two types i.e.

• Direct Taxes: In case when the tax is levied directly on the personal income earned by the person or the personal assets held by the person then such tax is called a direct tax, i.e. where the burden of tax is directly on the person who incurs any earning or profits. Examples are Income Tax, Corporate Tax, etc.
• Indirect Taxes: In cases when the tax levied on the price of goods or services which is consumed by the person. Here, the incidence of tax keeps shifting from one person to another till the goods or service reaches the final consumer. Examples are Goods and Service Tax (GST), Custom Duty, etc.

Economic Effects of Taxation

The most important objective of taxation is to gather revenues to fund public expenditure but this is not the sole motive of taxation. Apart from public expenditure, taxation is used as an instrument to control and regulate the money supply and private expenditure as per the economic environment, to affect the pattern of consumption, production, and distribution. Taxes thus affect an economy in several ways, and it is not necessarily important that the effects of taxes may always be positive on the economy. So, the effect of taxation can be studied under three major heads:

• Effects of Taxation on Production
• Effects of Taxation on Distribution
• Other Effects of Taxation

I. Effects of Taxation on Production

1. Effect on the Ability to Work and to Save: Levying taxes can result in the depletion of disposable income of the taxpayers. This will result in reduction of expenditure on basic stuff which are required to be consumed for the sake of living and improved efficiency. As the efficiency of taxpayer suffers ability to work also declines due to lack of efficiency, and the affects can also be visible on savings and investment. However, it has been observed that the effects of taxation are clearly more visible on middle class or lower middle class section of society and rich class majorly remains unaffected by the effects of taxation, as they possess disposable income which can be exhausted to meet tax payments.

2. Effect on the Will to Work, to Save and to Invest: Any financial obligation denotes burden. Effect of taxation on willingness to Work, Save, and Invest deals with the psychological state of people’s mind, as people find taxation as a monetary burden. Taxes which are expected to continue in future, it will reduce the willingness to work and save of the taxpayers, whereas taxes which are of temporary nature i.e. to meet any emergency situation or to meet any environmental hazard or taxes which are imposed on gains like lottery income or online gaming do not produce such adverse effect on desire to work, save and invest.

3. Effect on Allocation of Resources: Proper allocation of resources can be the key factor for any economy to excel. Resources shall be diverted to the most important areas which can help to contribute towards overall growth of economy. By diverting resources to the desired directions, taxation can influence both volume and the size of production and the pattern of production in the economy. Such proper allocation could be beneficial on production. High taxation on harmful drugs, commodities and intoxicants will reduce their consumption which will discourage production of these commodities and the available resources will now be diverted for the production of essential commodities which are useful for economic growth.

II. Effects of Taxation on Distribution

Levying of Taxation has both favourable and unfavourable effects on the distribution of income and wealth. To understand the effects of taxation on distribution, the nature of taxation which is adopted in an economy is need to be taken under consideration.

1. Effects of Regressive Taxation on Distribution: Imposition of regressive taxation system will create a gap between rich and poor. Under Regressive Taxation System, rich becomes be richer and poor becomes poorer. The burden of taxation falls more on poor as compared to rich section of society, as the same tax rates will be applicable to all without consideration given to individual income slabs.

2. Effects of Proportional Taxation on Distribution: Under the Proportional Taxation, a uniform rate of taxation is applied on rich and poor. In this case, where the tax rate remains the same, it will create inequalities between them as the tax rate will be same for low, middle and high income classes and that is why they are also called as Flat Tax.

3. Effects of Progressive Taxation on Distribution: Progressive taxation aims to promote equality among individuals. Here, the tax rate progresses as taxable income increases. It means that individuals with low incomes will be taxed at lower rates than individuals with higher incomes.

III. Other Effects of Taxation

1. Effect on Employment: In case where the taxation revenue is deployed to set up industries and are utilised on development projects then the outcome of such deployment of resources will help in generating employment opportunities. Excess capital available with people due to low taxes might help in setting up of new business. On the other hand, when the taxation policy affects the economy negatively, then it will effect employment and capital formation adversely.

2. Regulatory Effect: Taxation is not only a tool to generate revenue but is also a tool to regulate consumption and production. Taxation has a direct effect on the scale of production. If the government wants to curb the production of a particular commodity, heavy taxation is levied, which will lead to an increase cost, customers will react instantly and the demand of the product will decrease. Similarly, in a case when government wants to scale up the production of certain commodities, government will lift up tax, or will provide tax exemptions and concessions which will result in a decreased price offering to customer and the demand shall increase and so will be the production.

3. Effect on Price Stability: Taxation is an instrument available with government, and the same is used to stabilise price during inflation. During the time of inflation, public look for government to erupt the economy and government use taxation as a tool. The main objective during inflation is to reduce the prices as early as possible, in order to do this government increases the tax rates, which results in lowering the purchasing power and stabilising the prices.