The Effects of Taxation on the Economy

Taxes are prevalent throughout many of the world’s economies, and although they serve to fund essential government services, taxes are not popular among consumers or producers. The proposition “taxes levied on goods and services always cause harm and distort the efficient operation of the economy and therefore should not be levied” is fundamentally correct, albeit a few caveats. To say something always causes harm sets tone for the failure of the claim. Instead, one might argue, that economically speaking, taxes should not be levied because it causes harm and distorts the efficient operation of the economy generally. However, even with that caveat, there remains a societal factor that simply cannot be accounted for by economic theory: without taxation there would be no services or restrictions offered for the general populous.

By simple definition, in a competitive market, that no single consumer or producer is able to influence the price of a similar good or service. An untaxed competitive market allows for the laws of supply and demand to operate optimally, with individual producers easily able to tailor their output to suit the specific needs of consumers. However, no matter where in the production process the tax is levied, it is an external factor that directly affects the price of the good for the consumer to purchase or for the producer to produce. If the price of a good increases, perhaps due to a sales tax, then demand for the product decreases per the law of demand as each consumer has its own buying price, in which the consumer weighs the price of the good relative to the need for the good. If the price exceeds the consumer’s need for the good, the consumer will not purchase the good. Producers fear that if taxes are levied on their goods, they will lose consumers who have lower price points. The inverse is true if the tax is levied in production, e.g. a tax on using certain tracts of land for mining. When production becomes more expensive, due to the attainment materials necessary to manufacture of a good, the company selling the good must then produce a lesser amount, driving the supply down and the consumer demand up. The price of the good is then increased, making it less attainable for consumers, who will have to turn to substitute products. Whether viewed from the consumer’s or producer’s vantage, levying taxes on a good or service restricts the overall pool of the product.

Although factoring tax incidence does directly affect how much extra either the buyer or seller is paying for a good or service, imposing a tax on a good or service creates inefficiency, except when there is perfectly inelastic demand or perfectly inelastic supply. As stated in the Chapter 6 notes, “a tax shifts the supply curve, decreases the equilibrium quantity, raises the price to the buyer, and lowers the price to the seller.” Taxes directly cause the number of goods produced to lower, leading to underproduction and quantity inefficiency. The deadweight loss as a result of taxation is harmful to buyers, who have less supply because producers simply cannot produce as much. This could result in angry consumers questioning the price increase and lack of product. Placing the entire tax burden on the producer makes it impossible to achieve production efficiency, since the producer won’t be able to achieve their maximum potential output due to increased production costs associated with taxes, or could lead to defective products as the producer may choose quantity over quality. Conversely, placing the entire tax burden on the consumer increases the likelihood that buyers will seek out substitute products, harming the untaxed producer. Unless the good or service is an absolute necessity (inelastic) and there are no other options to procure the product, a competitive market will have many other options available to which consumers to choose. For example, if a bank increases the charge paid by its customers when they use ATMs owned by other banks, then those customers are more likely to find a bank that doesn’t have fees for using accessible ATMs other than their own bank’s ATMs.

Typically, both producers and consumers, as seen in the example of the 2002 New York City cigarette tax, share the tax burden. (Myers) Despite the high tax imposed on the good, cigarettes, the demand is inelastic as those who are addicted to cigarettes will gladly pay more to keep smoking. But perhaps, the tax deters casual smokers from buying the cigarettes on a whim. Depending on the amount taxed, the producer may be able to achieve the same revenue despite the tax if they are able to cut costs elsewhere. For instance in the trucking industry, if consumers (the trucking company) pay heavy taxes on gasoline or diesel fuel, upgrading their fleet to be more energy efficient by using clean natural gas or electricity can help them offset some of the tax burden created in the production and distribution of their product.

Concerning the IRS and taxes, tax codes can also be reformed in order to provide the greatest amount of efficiency by adjusting tax incentives. As long as a tax system offers useful incentives, then the levying of those taxes can be deemed acceptable. In a 2011 testimony before the Senate Finance Committee, Dr. James K. Galbraith laid out which incentives in the American system he believes work best for its citizens: “the interest deduction on good mortgages, the earned income tax credit or the deduction for municipal bonds,” and the estate tax, which he argues helps the wealthiest Americans engage in philanthropy. Other types of tax incentives include the investment tax. Having an interest low tax on investments increases the likelihood that consumers will invest in the national economy, thus increasing the overall GDP of the nation. Galbraith goes on to question outright the usefulness of the payroll tax, the largest direct tax paid by American workers, which he sees as useless and a detriment to job creation. For the worker, the tax reduces their ability to autonomously spend because they have less expendable income. By the same gesture, when American companies who hire workers are taxed, the companies can no longer employ a full working staff. Due to taxes, the pool of revenue allocated worker income decreases and therefore the pool of workers must also decrease, causing job loss. Galbraith points out that that payroll tax relief helps increase disposable income for employees and reduces the cost of job creation for employers. As long as consumers and producers have reasonable incentives attached to their taxes, then there is a greater likelihood that the economy will be able to operate efficiently despite the presence of taxes. Taxes are necessary to provide funding for government projects and programs that promote the betterment of people’s lives despite economically limiting certain aspects of their lives, therefore, whenever and wherever taxes are implemented, policymakers must ensure that the tax code is designed to maintain as much economic efficiency as possible.

While taxes do make the economy less efficient, in order for society to function properly, taxes must exist. For goods that have characteristics such as a high risk of abuse or a tendency to be associated with criminal activity, it makes sense to levy a tax in order to prevent the negative consequences of societal overconsumption of dangerous goods widely available to the public uncensored. To combat this outcome, taxes are particularly imposed on the consumer. In the United States, excise taxes on alcohol, tobacco products, and firearms are not well-liked by the general populace, but without them, there would be severely decreased funding for trusts providing money for projects such as the Highway Trust Fund and the Mass Transit Account. (Joint Committee on Taxation) Another benefit of taxation is better infrastructure. Increased quantity and quality infrastructure benefit both producers, who have an easier time getting their goods and services to markets, and consumers, who then enjoy access to a wide variety of products due to the producers’ increased ability to get around. Although taxes create economic inefficiency by harming both producers and consumers, changing the price of goods and services, and preventing a truly competitive market from formulating, they are necessary for the societal good.

References

Myers, S. Chapter 2: The economic problem [PowerPoint slides]. Retrieved from Springboard:

Myers, S. Chapter 3: Demand and supply [PowerPoint slides]. Retrieved from Springboard:

Myers, S. Chapter 4: Elasticity [PowerPoint slides]. Retrieved from Springboard:

Myers, S. Chapter 5: Efficiency and equity [PowerPoint slides]. Retrieved from Springboard:

Myers, S. Chapter 6: Markets in action [PowerPoint slides]. Retrieved from Springboard:

The Joint Committee on Taxation. (2011). Testimony of the staff of the Joint Committee on Taxation before the Joint Select Committee on Deficit Reduction [PDF file]. Retrieved from https://www.jct.gov/publications.html?func=startdown&id=4363

United States Senate Committee on Finance. (2011). Does the tax system support economic efficiency, job creation, and broad-based economic growth? [PDF file]. Retrieved from http://www.finance.senate.gov/hearings/hearing/download/?id=c227a63b-60ae-4f12-843b-fc668fed7800