What’s it: An induced tax is a tax in which the rate increases and decreases depending on the taxpayer’s ability. So, when our income or wealth rises, we have to bear high rates. Conversely, a decrease in income leaves us with a lower tax bill. Taxes are usually expressed as a percentage of taxable income.
Induced taxes have become one of the fiscal tools to influence the economy. It works counter cycle. As long as the economy is prosperous, the tax rises due to higher incomes, prompting people to reduce people’s incentives to shop. Conversely, when the economy is sluggish, the tax tends to fall due to a deteriorating income outlook. These tax increases and decreases occur automatically, without any intentional intervention by the government.
Induced taxes are important to avoid excessive deviations in the output gap. It avoids negative effects such as uncontrolled inflation rates during economic expansion by dampening aggregate demand. On the other hand, it prevents the economy from falling further during a recession – which could lead to a great recession.
What are examples of induced taxes?
Personal income tax and corporate profits are examples of induced taxes. When income or profits go up, we have to pay higher taxes. And, when it goes down, our tax bill is lower.
When the government implements it progressively, it has a stronger effect on household consumption and business investment. It is because we have to bear higher tax rates when our income rises. For example, say we are single, and our income is $9,951 to $40,525 per year. In that bracket, we bear a 12% tax rate. But, when our income rises above $40,525, we can bear the 22% rate.
How does induced tax work?
Induced taxes are applied as a percentage of taxable income. The rate may be applied proportionally so that, when our income rises, our tax bill rises even though we bear a fixed tax rate.
Alternatively, the tax rate is imposed progressively where a higher percentage is charged for higher taxable income. In contrast, smaller taxable income bears a lower percentage. Higher or lower bills ultimately impact the dollars available for consumption and investment, affecting how households and businesses spend money.
Take the tax brackets imposed by the Federal government in the United States as an example. Its implementation is progressive. Say, brackets $0 to $86,375, subject to the following rates:
|Tax rate||Taxable income|
|10%||$0 – $9,950|
|12%||$9,951 – $40,525|
|22%||$40,526 – $86,375|
For example, suppose we have a taxable income of $8,000. We are charged a 10% rate because our income is in the $0 – $9,950 range. Others with $7,000 or $9,000 million in income will bear the same rate.
However, when our income rises beyond the upper limit of the range, we incur a higher percentage rate. For example, say our income rises to $11,000, we fall in the $9,951 – $40,525 bracket and are charged a 12% rate. However, we do not bear the 12% rate on our entire taxable income. Instead, we charge a 10% rate on the first $9,950, and the remainder, $1,050, is subject to a 12% rate.
Thus, when our taxable income is higher than the upper limit of the bracket, we will incur a higher rate for each subsequent additional income. And because of that, fewer dollars are available for us to spend or save for each additional income we earn. Without the higher rates, we might spend or save that extra income.
How does induced tax work as an automatic stabilizer?
Automatic stabilizers are counter-cyclical fiscal tools and work automatically without the government’s deliberate action. Unemployment benefits and welfare payments are examples. Induced taxes are another example. Both affect the economy through their effect on aggregate demand.
What is a counter cycle? What I mean is that these tools work against the current economic cycle. During expansion, households prosper, and unemployment falls. Therefore, government spending on unemployment benefits will fall. On the other hand, taxes will increase as the outlook for household income and corporate profits increases during this period. They see strong prospects for their income and profits. The decline in government spending and the increase in taxes ultimately moderated aggregate demand, preventing it from accelerating too quickly and dampening uncontrolled increases in the price level (inflationary pressures).
In contrast, during a recession, the economy struggles. As a result, government spending on unemployment benefits will increase due to a higher unemployment rate. On the other hand, the outlook for household income and business profits is deteriorating, lowering taxable income. Higher unemployment benefits and lower tax rates help households maintain consumption. Thus, their demand for goods and services does not fall further during a difficult economy.
Induced tax as an automatic stabilizer
When the economy faces a recession, taxable income falls. Applying the tax bracket above, households bear lower rates. Let’s say their taxable income drops from $11,000 to $9,000. They will bear a flat rate of 10% from the previous 12% for any additional taxable income. As a result, the total income tax they pay will also decrease. If previously, with $11,000 in taxable income, they had to pay $1,121 in taxes (9,950 x 10% + 1,050 x12%), they are now paying only $900 ($9,000 x 10%). As a result, the tax bill is lower.
A lower tax bill moderates the fall in aggregate demand due to a decline in income. Households have to spend fewer dollars on taxes, leaving them with enough money to sustain their consumption.
Meanwhile, during the economic expansion, the outlook for household income improved. As a result, taxable income tends to be higher during this period. Finally, the household must pay a higher tax rate, say from 10% to 12% (the opposite of the above).
A higher tax bill (from $900 to $1,121) reduces households’ incentives to spend more. They have to spend more dollars to pay taxes and less available to spend on goods and services. As a result, it prevents aggregate demand from accelerating, cushioning upward pressure on the price level and preventing the economy from overheating.
Effect on government budget
The government’s revenue from income taxes falls during the recession. On the other hand, government spending on welfare benefits increased. As a result, the government budget leads to a deficit.
On the other hand, during expansion, tax income increases due to higher economic activity. Household incomes and business profits increased, allowing the government to collect more taxes. On the other hand, spending on welfare benefits because society is more prosperous during this period. As a result, the government budget leads to a surplus.