Taxation

Taxation can be used to finance government expenditure or to service the national debt. It can also be used to promote welfare or to change the distribution of income or wealth, and it can have the unintended effect of reducing welfare. Its use as an instrument of fiscal policy is considered in a separate article on that subject.

Note This article deals with the social and microeconomic effects of taxation at a given state of public expenditure. The macroeconomic effects of taxation, and the effects of varying combinations of taxation, public expenditure and debt, are dealt with in the article on fiscal policy.

The effects of taxation

Every combination of the various forms of taxation has a different effect upon welfare, but they all have certain common features. In the terminology of economic theory, each of them has an income effect, and most of them have substitution effects. The income effect is the reduction in the resources available to taxpayers that is brought about by the transfer of resources to government. It occurs, therefore, without affecting the total of the country's resources. The substitution effect, on the other hand, may result in a reduction in the country's resources by bringing about a move to less productive activity. An increase in income tax may, for example, induce a skilled worker to reduce his working hours and spend more time on untaxed do-it-yourself activities. The resulting reduction in output would have the indirect effect of reducing national welfare. The substitution effect may alternatively have a direct effect of welfare by prompting taxpayers to buy products other than those that they would otherwise prefer. A tax on biscuits, for example, may prompt buyers to switch to an untaxed but less enjoyable product, such as bread. The size of the substitution effect depends upon the extent to which the tax varies with a level of activity (the marginal tax rate) and to the responsiveness of the level of that activity to its price (the elasticity of supply or demand). Taxes that have no effect upon supply or demand, such as a land-value tax or a poll tax, have no substitution effect, and activities whose level is relatively insensitive to price (such as purchases of bread) have relatively small substitution effects. Other things being equal the more numerous the persons or activities on which the tax is leveled (ie the larger the tax base), the smaller is likely to be the substitution effect because the lower are the marginal tax rates

A second common feature is the effect of taxation upon the distribution of income and wealth. Taxation may be expected to alter the distribution of income or wealth. The term ‘’vertical distribution’’ refers to distribution among people having different levels of income, and the term ‘’progressive tax’’ denotes a tax which bears progressively more heavily on higher- income taxpayers. However, a tax which is the same whatever the taxpayer’s income, such as a poll tax, is termed ‘’regressive’’ because it is harder for low-income taxpayers to afford it. The term ‘’horizontal distribution’’ is correspondingly taken to refer to the distribution of taxation among taxpayers who have similar levels of income, but the term is open to a variety of interpretations. The reduction of, or exemption from, tax liability for specific classes of potential taxpayer is often referred to as a ‘’tax break’’ and is indistinguishable from subsidies in favour of those classes. Tax breaks for specific activities, such as research and agriculture - or for specific classes of organisation, such as charities, are intended to encourage those activities or organisations; and tax breaks for specific classes of individual such as the elderly or mothers with small children, are often intended to alter vertical distribution.

The burden of taxation may not be confined to those who pay the tax, however. Producers may be able to pass a part of any tax increase taxes on to consumers by increasing prices or on to employees by reducing wages, and employees may be able to pass a part of any income tax increase on to producers by raising wages. The extent to which such shifting of the tax burden occurs depends upon conditions in the relevant product and labour markets.

Taxes on income

Income tax is usually used to reduce inequality by taking a proportion of income that rises with rising income (an arrangement that is termed "progressive"), but that can lead to a loss of national income resulting from the relatively high marginal tax rates that it implies.

Taxes on employment income can affect the supply of labour as a result both of its price effect - to the extent that it makes employees try to compensate for their loss of after-tax earnings - and its substitution effect - to the extent that it makes employees willing to sacrifice their reduced net earnings in exchange for the unchanged the benefits of increased leisure. Empirical evidence tends to indicate that income tax has a negative effect the effect that is larger for female labour than for male labour, and that it is greater for both when tax rates are progressive. The combined influence of employment income taxation and means-tested state benefits can also reduce the supply of labour as a result of the operation of the unemployment and poverty traps.

Taxes on employment income can also affect the demand for labour as a result of the tax wedge that is driven between he cost of labour to employers and the net payment received by employees. The magnitude of the effect upon unemployment depends upon the price flexibility in the relevant labour market, because it depends upon the extent to which employees seek to pass a tax increase on to their employers .