Economic effect of taxation is all about the effect of taxation and tax to the activities of those to whom the tax burden is levied. Every tax system produces various types of consequences on an individual’s economic activities. These consequences may be favorable or unfavorable to the tax payer economically.
The best system of taxation is from an economic point of view is one with the least unfavorable consequences or the best economic effects on the general activities of the tax payer. The effects of taxation can be summarized into three: effect of taxation on production, effect of taxation on distribution and the effect of taxation on investment.
Effect of taxation on production
The effects of taxes on the production activities can be divided into four. They include the effect on
The ability to work and save
Desire to work and save
Composition and pattern of production
Supply of factors of production
The ability to work and save: Taxes normally from the tax payer’s point of view reduce an individual’s efficiency and ability to work and hence and effect on the productive ability of an individual. This is because when taxes are levied on an individual, they reduce the purchasing power of an individual forcing them to cut down on their consumption expenditures. This effect is more pronounced in the case of lower and middle income groups compared to the upper income groups
Taxes also adversely affect the ability of people to save. Savings depend on a person’s disposable income. All taxes reduce a person’s ability to save If a tax payer maintains the same standard of living after the imposition of taxes and does not reduce his/her consumption expenditure then he will have to save a little or not save at all. However the reduction is felt more by the low income earners who have a lower propensity to save.
Desire to work and save: Taxes also affects production through the desire to work and save. The desire to work and save depends on the nature of taxes and the nature of an individual’s reaction to taxes.
Nature of taxes can be explained as, when moderate taxes are imposed on an individual it will not affect the incentive to work compared to heavy commodity taxes which have the effect of reduction in production activities due to decline in demand caused by higher prices. Also highly progressive taxes income taxes such as PAYE will discourage the willingness to work, save and invest. This is because a tax payer is discouraged by the fact that more effort in terms of work and investment leads to higher income and consequently higher taxes. An individual thus relaxes in order to pay lesser tax proportionate to his earning because he feels that a good proportion of his effort might be lost to the government through taxation.
Nature of an individual’s reaction to taxes on the other hand can be explained as the immediate reaction of a tax payer to the tax proposals in the budget. It is also known as the ‘announcement effect’. It is not always the same for all tax payers. It depends on an individual’s elasticity of demand for income. Elasticity of income is defined as the intensity of desire for obtaining a particular level of income. It is usually inelastic for most people because they usually work to improve their living standards, save to start businesses, acquire power wealth and prestige. For such people whenever taxes are imposed on them or raised there is effort on their part to increase their incomes and hence a desire to work and save for such people brought about by taxation and vice versa for the income elastic ones.
When the government imposes taxes on socially undesirable products like cigarettes there can be a diversion of resources from the production of these to some that is considered socially desirable, when the government grants tax incentives and concessions to businesses willing to operate in certain regions in the country there can be a movement of production resources in these areas, when the government protects certain local industries through tax incentives there can be diversion of resources from non-priority sectors to these protected sectors the presence of high taxes in a country can lead to capital flight by foreign investors which may disrupt the production activities in certain sectors of the economy.
Supply of factors of production: The tax policy initiated by the government may have some effect on the general supply of the factors of production and consequently on the production activities. On land tax policies do not have an effect on land but an effect on the utilization of land through the imposition of idle land tax as a way of encouraging land owners to develop their pieces of land. For labor, tax has a minimal effect on the supply of labor. However taxation has an impact on the utilization of labor hey may affect since they may affect a person’s willingness to work. In developed countries tax is a major consideration before seeking employment and some even leave the domestic labor market to relocate to tax havens.
Tax affects both supply and utilization of capital. This is because the major source of capital is usually ones saving which usually depends on one’s disposable income which is normally reduced by tax. On utilization if the tax burden on the returns of tax is high many shy away from participating in capital markets. For entrepreneurship, individuals normally go into it in order to generate profits. If taxes imposed on them are high they normally avoid entrepreneurial ventures.
Effect of Taxation on Distribution
One of the most essential objectives of taxation is the fair distribution of income and wealth. A good tax policy is one that tries to reduce as much as possible the gap between the rich and poor. A tax system that is either regressive or proportional tends to increase the gap. Also, indirect taxes on the necessities of life also tends to increase the gap because the low income earners depend most on such commodities while indirect taxes on luxuries and comforts tends to minimize the gap because it is high income people who tend to purchase to purchase these commodities.
Effect of taxation on Investment
Taxes may adversely affect the level of investment in the economy. It can also be used as an incentive for encouraging both local and foreign investment. Taxes also reduce the disposable income of an individuals and households and thus savings and investments. Huge taxes on profits of businesses also discourage one from doing certain businesses.
Business Training in Kenya has more information on this topic.
Conclusion on Economic Effect of Taxation
A good tax system should be one that places favorable economic effect of Taxation to the tax payer and also encourages productive activities to all to whom it is subjected.
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