Tax Matters

The most important objective of taxation is to raise required revenues to meet expendi­tures. Apart from raising revenue, taxes are considered instruments of control and regulation to influence the pattern of consumption, production, and distribution. Taxes thus affect an economy in various ways, although the effects of taxes may not necessarily be good. There are the same bad effects of taxes too.
The economic effects of taxation can be studied under the following headings:
Effects of Taxation on Production: Taxation can influence production and growth. Such effects on production are analyzed under three heads:
*Effects on the ability to work, save and invest
*Effects on the will to work, save and invest
*Effects on the allocation of resources.

Effects on the Ability to Work Save:
The imposition of taxes results in the reduction of the disposable income of the taxpayers. This will reduce their expenditure on necessaries which are required to be consumed for the sake of improving efficiency. As efficiency suffers ability to work declines. This ultimately adversely affects savings and investment. However, this happens in the case of poor persons.
Taxation on rich persons has the least effect on the efficiency and ability to work. Not all taxes, however, have adverse effects on the ability to work. There are some harmful goods, such as cigarettes, whose consumption has to be reduced to increase the ability to work. That is why the high rate of taxes is often imposed on such harmful goods to curb their consumption.

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But all taxes adversely affect the ability to save. Since rich people save more than the poor, a progressive rate of taxation reduces savings potentiality. This means a low level of investment. A lower rate of investment has a dampening effect on the economic growth of a country.
Thus, on the whole, taxes have a disincentive effect on the ability to work, save and invest.

Effects on the will to Work, Save, and Invest:

The effects of taxation on the willingness to work, save and invest are partly the result of the money burden of tax and partly the result of the psychological burden of a tax.
Taxes that are temporarily imposed to meet an emergency (e.g., Kargil Tax imposed for a year or so) or taxes imposed on windfall gain (e.g., lottery income) do not produce adverse effects on the desire to work, save and invest. But if taxes are expected to continue in the future, it will reduce the willingness to work and save the taxpayers.
Taxpayers have a feeling that every tax is a burden. This psychological state of mind of the taxpayers has a disincentive effect on the willingness to work. They feel that it is not worth taking extra responsibility or putting in more hours because so much of their extra income would be taken away by the government in the form of taxes.
However, if taxpayers are desirous of maintaining their existing standard of living during the payment of large taxes, they might put in extra efforts to make up for the income lost in tax.
It is suggested that the effects of taxes on the willingness to work, save and invest depends on the income elasticity of demand. The income elasticity of demand varies from individual to individual.
If the income demand of an individual taxpayer is inelastic, a cut in income consequent upon the imposition of taxes will induce him to work more and save more so that the lost income is at least partially recovered. On the other hand, the desire to work and save those people whose demand for income is elastic will be affected adversely.
Thus, we have conflicting views on the incentives to work. It would seem logical that there must be a disincentive effect of taxes at some point but it is not clear at what level of taxation that crucial point would be reached.

Effects on the Allocation of Resources:
By diverting resources to the desired directions, taxation can influence the volume or the size of production as well as the pattern of production in the economy. It may, in the ultimate analysis, produce some beneficial effects on production. High taxation on harmful drugs and commodities will reduce their consumption.
This will discourage the production of these commodities and the scarce resources will now be diverted from their production to the other products which are useful for economic growth. Similarly, tax concessions on some products are given in a locality which is considered backward. Thus, taxation may promote regional balanced development by allocating resources to the backward regions.
However, not necessarily such a beneficial effect will always be reaped. Some taxes may produce some unfavorable effects on production. Taxes imposed on certain useful products may divert resources from one region to another. Such unhealthy diversion may cause a reduction in consumption and production of these products.

Effects of Taxation on Income Distribution:
Taxation has both favorable and unfavorable effects on the distribution of income and wealth. Whether taxes reduce or increase income inequality depends on the nature of taxes. A steeply progressive taxation system tends to reduce income inequality since the burden of such taxes falls heavily on the richer persons.
But a regressive tax system increases the inequality of income. Further, taxes imposed heavily on luxuries and non­essential goods tend to have a favorable impact on income distribution. But taxes imposed on necessary articles may have a regressive effect on income distribution.
However, we often find some conflicting roles of taxes on output and distribution. A progressive system of taxation has a favorable effect on income distribution but it has disincentive effects on output.
A high dose of income tax will reduce inequalities but such will produce some unfavorable effects on the ability to work, save, invest, and, finally, output. Both the goals—the equitable income distribution and larger output—cannot be attained simultaneously.

Other Effects of Taxation:
If taxes produce favorable effects on the ability and the desire to work, save and invest, there will be a favorable effect on the employment situation of a country. Further, if resources collected via taxes are utilized for development projects, it will increase employment in the economy. If taxes affect the volume of savings and investment badly then the recession and unemployment problem will be aggravated.
Again, the effect of taxes on the price level may be favorable and unfavorable. Sometimes, taxes are imposed to curb inflation. Again, as an imposition of commodity taxes lead to rising costs of production, taxes aggravate the problem of inflation.
Thus, taxation creates both favorable and unfavorable effects on various parameters. Unfavorable effects of taxes can be wiped out by the judicious use of progressive taxation.