Taxation

Taxation is used to finance public 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.

Introduction

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 taxonomy of taxation is discussed on the addendum subpage. A glossary of the terms shown in italics in this article is available on the related articles subpage

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.

Effects at the aggregate level

It is generally accepted that endogenous growth theory provides a strong presumption that the net effect of taxation is to reduce economic growth as a result, for example, of its negative influence upon innovation and upon the development of human capital. A survey of the empirical evidence has concluded, however, that it does not support that aggregate presumption, although it does throw light upon the effects of some tax instruments..

Effects of individual taxes

Personal income tax

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 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 are able to pass a tax increase on to their employers . There is also evidence that high tax rates for low earners can increase unemployment among low-skilled employees, especially at relatively high levels of the minimum wage.

The substitution effect of personal taxation may be expected to reduce the motive for saving as a result of the reduced after-tax return but the income effect may prompt an increase in savings in order to preserve a desired level of retirement income. Empirical evidence concerning the magnitude of the net effect has yielded widely differing findings but there is general agreement that the outcome is a reduction in savings. There is also some evidence to suggest that income tax may reduce human capital as a result of its effect upon the willingness of parents to spend money on their children.

The above effects suggest the possibility that high marginal tax rates have negative consequences for productivity, and an OECD study has indicated that progressive income tax can cause significant reductions in GDP per head in addition to effects arising from reduced acquisition of human capital,

Corporate income tax

There is no apparent advantage to be gained from adding the indirect taxation of the sources of investment income by taxing company profits to its direct taxation as part of personal income taxation - although it was suggested in the Meade Report that it might be considered to be a payment for the privileges of limited liability. A tax on corporate profits has the drawback of discouraging investment by reducing its rate of return (although alternatives can be envisaged that avoid that disadvantage). Investment decisions are distorted if debt and equity are treated differently but other difficulties can arise if that is to be avoided . Also, international differences in tax treatment can influence location decisions, especially of multinational companies - a consideration that has probably acted as restraint upon governments.

Taxes on consumption

Taxes on consumption should not have the discouraging effect upon saving that has been attributed to personal income tax, and there is limited empirical evidence that its substitution for income tax leads to an increase in saving, and it is often claimed that they are better for growth than taxes on income. They are often termed "regressive", however, because they may be expected to bear relatively heavily on the poorer families if they are levied on goods that account for a relatively high proportion of their spending.

Social security contributions

Whether they are regarded as taxes or insurance premiums, social security contributions have the same effects as taxes and they form part of the tax wedge that is driven between the cost of labour to employers and the net payment received by employees.

Wealth and property taxes

The principle effect of the taxation of personal property and wealth is redistributive and there is little evidence of their influence upon the level of economic activity.

Environmental taxation

The purpose of the environmental taxes that were introduced in the latter part of the 20th century was to prevent the loss of economic welfare that would otherwise result from various forms of environmental pollution. They were supplemented in the 21st century by taxes that were introduced to guard against the danger of the very large long-term economic costs of adapting to global temperature rises of several degrees centigrade. A review undertaken for the British government has concluded that the economic costs of measures to avert that outcome will be substantially outweighed by reductions in the cost of adaptation . A review by economists at the National Bureau of Economic Research has concluded that environmental tax revenues do not significantly alter economic constraints on tax policy, and that environmental taxes need to be justified primarily by the cost-effective achievement of environmental goals.