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.

The effects of taxation

Every combination of the various forms of taxation has a different effect upon welfare, but all of them 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 their transfer 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 product such as bread.