Effects of Taxes | Economics Optional Notes for UPSC PDF Download

Introduction

The most important objective of taxation is to raise required revenues to meet expendi­tures. Apart from raising revenue, taxes are considered as instruments of control and regulation with the aim of influencing 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 same bad effects of taxes too.

Effects on the Ability to Work Save

• Imposition of taxes results in the reduction of 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 ability to work. That is why high rate of taxes are often imposed on such harmful goods to curb their consumption.
• But all taxes adversely affect ability to save. Since rich people save more than the poor, progressive rate of taxation reduces savings potentiality. This means low level of investment. Lower rate of investment has a dampening effect on economic growth of a country.
• Thus, on the whole, taxes have the 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 money burden of tax and partly the result of psychological burden of tax.
• Taxes which are temporarily imposed to meet any 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 future, it will reduce the willingness to work and save of 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 in the midst of payment of large taxes, they might put in extra efforts to make up for the income lost in tax.
• It is suggested that effects of taxes upon the willingness to work, save and invest depends on the income elasticity of demand. 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 to save more so that the lost income is at least partially recovered. On the other hand, the desire to work and save of 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 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 as backward. Thus, taxation may promote regional balanced development by allocating resources in the backward regions.
• However, not necessarily such beneficial effect will always be reaped. There are some taxes which may produce some unfavourable effects on production. Taxes imposed on certain useful products may divert resources from one region to another. Such unhealthy diversion may cause reduction of consumption and production of these products.

Effects of Taxation on Income Distribution

• Taxation has both favourable and unfavourable 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 favourable impact on income distribution. But taxes imposed on necessary articles may have regressive effect on income distribution.
• However, we often find some conflicting role of taxes on output and distribution. A progressive system of taxation has favourable 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 unfavourable effects on the ability to work, save, investment and, finally, output. Both the goals—the equitable income distribution and larger output—cannot be attained simultaneously.

Other Effects of Taxation

• If taxes produce favourable effects on the ability and the desire to work, save and invest, there will be a favourable 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 recession and unemployment problem will be aggravated.
• Again, effect of taxes on the price level may be favourable and unfavourable. 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 favourable and unfavourable effects on various parameters. Unfavourable effects of taxes can be wiped out by the judicious use of progressive taxation.