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What’s it: A tax is a mandatory levy by the government on an individual or other entity. There are many variations, including income tax, value-added tax, and capital gains tax. It has become the main source to cover government spending in providing public services. In addition, changes in taxes affect economic activity. Governments use it to influence aggregate demand, output, unemployment, and inflation.
Understanding taxes and why it matters
Most government revenue comes from taxes. Meanwhile, other sources come from grants, natural resource compensation fees, dividends from state-owned enterprises, and asset sales.
The government uses taxes to finance essential services such as health, social security, education, defense, health, and transportation. It also uses them for capital expenditures such as building infrastructure.
There are several reasons to justify tax collection and why it is important. First, the government uses it as a tool to influence economic activity. Changes in taxes affect economic growth, unemployment, and inflation.
For example, the government cuts tax rates to stimulate economic growth. Lower rates leave households with more dollars to spend on goods and services, and businesses have more money to invest. As a result, increasing consumption and investment raises aggregate demand and pushes the price level up.
Benefitting from stronger demand and rising price levels, businesses will increase production to reap more profits and hire more labor. As a result, tax cuts will push the economy to grow higher, create more jobs, and raise inflation.
Second, taxes help to redistribute income and wealth in the economy. For example, the government allocates them for social spending or transfer payments, which helps the poor avoid acute poverty.
In addition, government spending on education is also important to create opportunities for children from poor families for a better life. With adequate access to quality education, they can improve their lives by gaining better skills and jobs.
Third, taxes protect the economy and domestic producers. Take, for example, import tariffs. Domestic producers may be faced with dumping practices, in which foreign producers sell their products cheaper in the domestic economy than in their home market. This unfair competition can destroy domestic producers and industries. Thus, by setting import tariffs, the government makes the dumped products more expensive when they arrive in the domestic market.
Fourth, the government can impose taxes on certain harmful goods, such as alcohol and tobacco. Or the government sets it up to limit negative externalities such as pollution.
In other cases, the government may impose tax breaks to stimulate positive externalities. For example, the government provides such incentives to encourage businesses to invest in green technology.
Tax principles
Taxation systems are often designed based on specific principles to ensure fairness, efficiency, and effectiveness. Here are two key principles:
Ability-to-pay principle
The ability-to-pay principle is a fundamental concept in taxation that suggests wealthier individuals and businesses should contribute a larger share of their income towards taxes compared to those with lower incomes. Progressive taxes, such as income tax with higher rates for higher earners, are based on this principle.
The ability-to-pay principle promotes fairness by ensuring the tax burden is distributed more evenly based on a taxpayer’s capacity to contribute.
Benefits principle
The benefits principle suggests that those who benefit from government services and programs should contribute more towards their funding. This principle often applies to user fees, where individuals pay directly for specific services they utilize, such as tolls for road maintenance or park entrance fees.
The benefits principle promotes efficiency by linking taxation to the use of government services. It encourages responsible use and potentially reduces the overall tax burden for everyone.
Different types of taxes
Maybe you are familiar with the following types of taxes:
- Personal income tax is levied directly on our income; it may come from wages, salaries, dividends, or investments.
- Corporate income tax is imposed on corporate profits, which is income minus expenses.
- Sales tax is imposed on retail sales of goods and services.
- Value-added tax is levied on the added value at each good or service supply chain stage.
- Payroll tax is paid on employees’ wages and salaries to finance social insurance programs.
- Excise tax is imposed on certain goods and services, such as alcohol and tobacco.
- Capital gains tax is levied on income earned from investments such as buying stocks, property, and bonds.
- Property tax is imposed on the immovable property such as land and buildings.
- Inheritance tax is levied on the value of inherited property and paid by those who inherit it.
- Stamp duty is paid on the sale of a single property or document.
- Carbon tax is imposed on those who emit excessive carbon.
There are several classifications for how the above taxes are collected and how the tax rates are imposed. Some are based on our income or wealth, and we pay for it right away. Others may be charged for the goods and services we consume, and we pay for them indirectly, through the market price we get.
Direct tax and indirect tax
The government imposes a direct tax on income, wealth, or profits. Personal income tax, property tax, and capital gains tax are examples. For example, when taxing our income, it is based on our income in one year; it can come from wages, salaries, dividends, interest, and other income. And we pay it directly to the government.
It differs from indirect taxes, which are levied on a transaction or expenditure on goods and services before reaching the consumer. Sales tax, value-added tax, and excise duty are examples. A value-added tax is levied at every stage of the supply chain, from manufacturing to distribution to sale. So, the price we pay considers the taxes paid at each stage.
Progressive, regressive, and proportional taxes
A progressive tax is imposed based on the taxpayer’s ability to pay. Therefore, those who are more affluent will pay higher rates than those who are less well-off. It can be based on income, wealth, or profit. Thus, when our wealth increases, we will bear higher tax rates. Income tax and capital gains tax are examples.
The opposite is a regressive tax. The tax rate decreases as the amount subject to tax increases. Thus, the tax burden decreases with income or wealth.
Meanwhile, the government imposes a proportional tax based on the same percentage. Thus, low-income taxpayers will pay the same rate as those with high or middle-income earners. Sales tax is an example of proportional tax, for which we have to pay the same fixed rate regardless of our income.
Ad valorem tax and specific tax
Ad valorem taxes are imposed based on the value of goods or services. So, even though the tariff is fixed, the nominal paid will increase when the price rises. For example, the tax rate on an item is 10%. Say the price goes from $100 to $150. As a result, the tax levied increased from $10 to $15.
Specific taxes are the opposite of ad valorem taxes. It is defined as a fixed amount for each unit of goods or services. For example, the tax on an item is $10 per tonne. Thus, the nominal levy remains unchanged even when the price rises or falls.
The impact of taxes on the economy
Taxes are a fiscal tool for influencing the economy. Changes can affect macroeconomic indicators such as aggregate demand, economic growth, unemployment, and inflation. For example, when the government wants to reduce inflation, it raises taxes. This policy is called contractionary fiscal policy.
Tax hikes reduce disposable income. As a result, households and businesses have fewer dollars to spend on goods and services, pushing aggregate demand down. Weaker demand triggers downward pressure on inflation as prices of goods and services fall.
This situation then encourages producers to reduce output and increase efficiency efforts. They cut their production in response to weaker demand. They began to reduce investment in capital goods and reduce labor. As a result, tax increases not only reduce inflation but also weaken economic growth and increase the unemployment rate.
The opposite effect occurs when the government cuts taxes. Lower taxes encourage consumption and investment to rise because households and businesses have more money to spend. As a result, aggregate demand increases, and the price level rises.
Rising prices encourage businesses to increase output. They see a good opportunity to reap more profits due to stronger demand. So they started investing in capital goods and recruiting labor to increase production and meet demand. As a result, tax cuts stimulate the economy to grow, lowering the unemployment rate and driving pressure on inflation upward.
Taxes and households
When the government imposes a tax on producers, it increases the cost of production. As a result, the supply curve shifts to the left, resulting in less quantity and a higher price.
Faced with higher costs, producers increase their selling prices to maintain profit margins. However, the increase resulted in fewer goods demanded by consumers. Thus, as demand weakens, producers have less incentive to maintain current production levels. As a result, they cut production, reducing output on the market.
Governments in some countries also use tax instruments to encourage multinational companies to invest. Lower tax rates attract them to invest, such as in setting up production facilities. Such investments contribute to building the economy and creating more jobs and income.
Impact on household
Lower taxes boost consumer demand. Households should set aside fewer dollars to pay taxes. Instead, more dollars are available to spend on goods and services. Increased demand shifts its curve to the right, prompting producers to increase output.
On the other hand, higher taxes raise the burden. As a result, disposable income decreases, and less money is allocated for spending on goods and services. Eventually, as demand decreases and the curve shifts to the left, the quantity and price in the market fall. Faced with weaker demand and falling prices, producers are reducing their output.
Taxes also affect consumer behavior. For example, taxing harmful goods such as tobacco and alcohol reduces their demand. As a result, their prices become more expensive, hoping consumers are reluctant to buy.
Then, the government also uses taxes to help redistribute income and wealth in the economy to citizens. For example, the government imposes a progressive tax by charging higher rates to wealthier individuals. Thus, poor people pay less and have more dollars to sustain themselves.
In addition, the government also uses taxes to fund welfare and social programs such as education, health care, and transfer payments. Such programs are important to ensure the poor have the opportunity to maintain a decent life and change their future.
Tax in the Government Budget
Taxes are the primary source of revenue for government budgets. Here are some specific concepts related to how taxes are integrated into the budgeting process:
Net tax
In macroeconomics, net tax refers to the total tax revenue collected by the government minus any transfer payments distributed back to citizens. This represents the government’s surplus or deficit from taxation used to finance public spending.
A positive net tax (surplus) indicates the government collects more in taxes than it distributes in transfers. This surplus can be used for debt reduction, increased spending in other areas, or a combination of both.
Conversely, a negative net tax (deficit) occurs when transfer payments exceed tax revenue. The government must then finance the deficit through borrowing or reducing spending elsewhere in the budget.
Induced tax
Induced taxes are those levied on the additional income generated due to government spending. For instance, if the government increases spending on infrastructure, it might lead to higher economic activity and income growth. Taxes collected on this incremental income can be considered induced taxes.
Induced taxes can be a significant source of revenue, especially when government spending leads to sustained economic growth. However, it’s important to consider the efficiency and effectiveness of the spending that triggers the induced tax revenue.
Laffer curve
The Laffer Curve is a hypothetical relationship between tax rates and tax revenue. It suggests that at very high tax rates, tax revenue might actually decrease as people have less incentive to work and earn income. Conversely, very low tax rates might also lead to lower revenue as the government collects less from each taxpayer. The Laffer Curve proposes an optimal tax rate that maximizes government revenue collection. However, the existence and precise location of this optimal rate remains a subject of debate among economists.
While the Laffer Curve offers a simplified view of a complex relationship, it highlights the importance of considering the impact of tax rates on economic behavior and overall revenue generation.
