Taxation on goods, income or wealth influence economic behaviour and the distribution of resources.
- For example, higher taxes on carbon emissions will increase cost for producers, reduce demand and shift demand towards alternatives.
- Higher income tax can enable a redistribution of income within society, but may have an impact on reducing the incentives to work and supply labour.
Taxation can have an impact on many aspects of the economy, including:
- Labour supply
- Labour productivity
- Economic growth
- Production and consumption of goods
- Saving rates/consumption
- Income distribution
- Resource distribution
- Levels of government spending
Impact of direct taxation – income tax
Income tax is a levy on income earned. In the UK, the basic rate of income tax is 20%. If there is an increase in income tax, what impact does it have?
- Raise revenue for the government. The main purpose of tax is to raise income for the government which can lead to higher spending on health care and education. The impact depends on what government spend the money on. For example, it may be necessary public sector investment (repairing roads) or it could be to fund shortages in pension funds)
- Less discretionary income. Those paying income tax will be left with less discretionary income to spend after income tax has been deducted. This is likely to lead to lower levels of household spending and lower levels of household saving. However, if the government spend the tax revenue – overall aggregate demand (AD) will not be affected.
- Incentive effect. Higher income tax reduces the take-home pay and can reduce the incentive to work. Either workers chose not to do overtime or even leave the labour market altogether. However, there are two conflicting effects of higher tax
- Substitution effect. Higher tax leads to lower wages – and work becomes relatively less attractive than leisure. The substitution effect of a higher tax is that workers will want to work less.
- Income effect. However, if higher tax leads to lower wages, then a worker may feel the need to work longer hours to maintain his target level of income. Therefore, the income effect means that higher tax may mean some workers feel the need to work longer.
- This means there is no guarantee of the impact of higher tax – it depends whether the substitution effect is greater than the income effect.
- Laffer curve. The Laffer curve is an analysis which suggests at some tax rates, higher income tax will reduce incentives to work and actually leads to lower tax revenue.
The Laffer curve is a source of dispute; the key question is at which level does higher income tax rates lead to lower revenue? One study suggests it would need to be a tax rate of over 70%
Impact on the distribution of income. Income tax is a progressive tax. In the UK, there is a tax threshold of £10,000, with a higher rate of income tax of 40%. As income rises, the percentage of income paid in tax increases. 16% of all income tax revenue is paid for by the top 1% earners. Income tax has a role in redistributing income and offsetting more regressive taxes, such as excise duty and indirect tax.
Impact of a higher tax burden
What is the effect of an increase in the overall tax burden? This is the % of GDP that is collected in tax. This can vary between countries. Generally, less developed economies have a lower tax burden, more developed economies have a higher tax burden.
For less developed economies, the tax burden tends to be lower because of difficulties in collecting taxes and less developed economic and political institutions.
To some extent, a rise in the tax burden shows a relationship with economic development. However, there are still variations – Sweden and the US have similar levels of GDP per capita, but the tax burden in Sweden (45%) is nearly double the US (25%). This reflects the more extensive welfare state (free health care, education) in Sweden than the US.
Some argue that the high levels of tax in Nordic countries can act as a disincentive to growth and investment. On the other hand, the stability of a welfare state, health care and education reduce uncertainty and problems such as health bankruptcy. There is no clear correlation between the tax burden and the rate of economic growth in the long term.
Impact of indirect tax
The impact of indirect tax is more of a microeconomic issue.
A higher tax on a good, shifts supply to the left causing higher price and less demand
A graph showing the impact of an ad valorem tax (20%) on a good
The impact of an indirect tax will depend on the elasticity of demand
Where demand is price inelastic (left), the tax leads to a rise in price from £10 to £14. The consumer burdern is £4 x 80. The producer receives £2 less so the producer burden is £3 x 80.
However, where demand is price elastic (right) the tax leads to only a small rise in price from £13 to £14. The consumer burden is relatively smaller.
Taxes and inflation
A rise in excise duty or VAT can lead to one-off price increases. Therefore, it tends to cause cost-push inflation. However, the inflationary impact of the tax increase will only last one year (unless it changes expectations of inflation).
Higher taxes during a time of stagnant wages can lead to a decline in real incomes. This shows the inflation rate in the UK. In 2011, CPI was over 5%. However, the inflation measure CPI-CT (which excludes taxes was lower at just 3%)
Tax and social efficiency
The logic of taxes on demerit goods and goods with negative externalities is to make consumers pay the social cost of the good and internalise the externality.
Without the tax, the market price of producing chemicals may be less than the social cost. The tax can increase the price to reflect the greater social marginal cost. In the above diagram, the tax of P2-P0 increases the price to P2 and reduces demand from Q1 to Q2.
Can tax reduce cigarette smoking?
Demand for cigarettes tends to be price inelastic. Because smokers are addicted they are willing to pay the higher price. Therefore, in the short-term, higher tax raises revenue for the government but has limited impact on reducing smoking rates.
However, over time, a high cigarette tax has been a factor in reducing demand. The high price may discourage people from starting to smoke. See: Cigarette tax and smoking rates