Tax effect on Production
1. Effects on Ability to work:
Taxes reduce disposable income. As such, the buying capacity and consumption expenditure are curtailed. These cause the standard of living to deteriorate. Consequently, efficiency and ability to work is adversely affected.
This happens in the case of low income group people. For the rich, however, the ability to work is not so much affected by taxation. To avoid the ill-effects of taxation, it is essential to grant exemption limits in income tax for the benefit of poor and middle income groups. In India, now an annual income up to Rs. 40,000 is exempted from income tax. Similarly, it is also necessary to avoid indirect taxes on essential commodities of mass consumption.
Again, there are some taxes which carry a beneficial impact on the ability to work. For instance, taxes on goods like liquor, cigarettes, opium, etc. which prohibit their consumption will lead to an improvement in general health and efficiency of those who are now addicted to them.
2. Effect on the Ability to Save:
All taxes always have an adverse effect on one’s saving capacity.
Ability to save is adversely affected by taxation as taxes fall on income and saving is the function of disposable income. As disposable income declines, savings tend to decline.
Though normally, taxation is on the surplus income (the income which is in excess of the minimum standard of consumption level), the ability to save will be reduced proportionally to the amount of taxation, as it will adversely affect the marginal propensity to save by reducing the surplus income out of which saving is generated.
Hence, taxation would cause a reduction in the saving potentiality. Especially, the rich, having a high marginal propensity to save, are affected most due to progressive taxation based on the ability to pay criterion. A progressive taxation substantially reduces the ability to save of the rich class.
Ability to save is also reduced by indirect or commodity taxation, because these taxes cause a rise in prices which induces a higher spending from a given income, thus, resulting in less saving.
Similarly, the corporate savings (that of business firms), too, are reduced by corporate taxation. Corporate ability to save is, however, less affected than a wealthy individual’s ability to save since equity does not demand progression generally in the taxation of corporate income.
But, when government spends the tax income for the benefit of the poor, then their ability to save is enhanced. So, while evaluating the effects of a tax, the effects of public expenditure should also be taken into consideration to appraise the correct position in the economic system.
It is equally true that when direct taxes are imposed, they absorb the excessive purchasing power of the commodity, cause a deflationary effect which in turn enhances the real income of the common people and their capacity to save.
3. Effect on Ability to Invest:
Ability to invest in the private sector evidently falls on account of the reduced saving ability caused by the tax imposition. Hence, all taxes have the immediate effect of reducing the amount of resources available for investment in the private sector.
In fact, taxation leads to a vicious circle in that when a tax is imposed, ability to save is reduced, less saving resources are available for investment in capital formation of the private sector, so there will be reduction in capital which in turn would lead to low productivity and low income, causing a further reduction in the ability of the people to save. As such, it may be stressed that to maintain and improve the investment function in a free economy, it is necessary to ensure that the rate of savings is not discouraged by taxation.
This gloomy picture of effect of taxation is, however, painted without taking into account the beneficial effects of public expenditure. In fact, public spending compensates and tends to surmount the adverse effects of taxation. The reduction in ability to work and save caused by taxation is more than mitigated by the amenities of life provided by State expenditure.
When the overall social benefits of expenditure exceed the social sacrifice involved in taxation, the net benefits of public spending will produce a favourable effect on the ability to save and work. Similarly, the reduction in private investment caused by taxation is more than offset by the public investment programmes.
In fact, the public sector investment may fill the investment gap of effective demand of the community and with due capital formation, can accelerate the tempo of economic development. Public investment may be designed to break the vicious circle of poverty in an underdeveloped economy. Thus, though analytically, the effects of taxation are discussed separately from those of public expenditure, in practice economic consequences of a fiscal policy can hardly be segregated.
Tax effect on Distribution
The effects of taxation on distribution depend on:
- Nature of taxes or tax rates
- Kinds of taxes.
By nature, taxation may be proportional, progressive or regressive. Progressive tax rates can reduce inequality as a larger amount of tax will be collected from the high income groups. A proportional tax rate causes no change in the relative income distribution in the society. A regressive tax implies a higher burden on the low-income groups; it, thus, tends to widen the gap of inequality. In short, progressive taxation can lead to a reduction in equality and realisation of egalitarian goals.
It is only under the steeply progressive tax system that the income and wealth inequalities would tend to be reduced, for a heavier direct real burden would fall upon the high income groups under the steeply progressive tax rates. The sharper the progressiveness, thus, the greater would be reduction in the gap of inequalities.
A progressive tax system is thus always preferred to proportional or regressive ones in the interest of equitable distribution. A progressive tax rate is, thus, justified on the ground of the principle of ability to pay.
A rich person having a greater ability to pay is taxed at a higher rate and the poor is exempted or taxed at a lower rate in a progressive tax system, so that the gap of inequalities in income and wealth is reduced by levelling down the high incomes. Thus, the greater the element of progressive rates in the tax system, the larger is the scope for improving distribution by reducing inequalities.
There is ample scope for making certain direct taxes (on income and wealth) very progressive which can help in reducing inequalities. For instance, an income tax may be made progressive by adopting a graded scale of tax rates, i.e., larger incomes being taxed at higher rates than the smaller ones.
Moreover, discrimination can also be made between earned and unearned income for taxation. Unearned income may be taxed at a higher rate, since there is no corresponding disutility in earning income from assets or property as in the case of income earned from work. In the interest of proportional sacrifice and equity also, therefore, income from work should be taxed less than income from property.
Further, equity is attained when income tax is levied according to one s ability to pay. For this reason, a very low income, necessary for subsistence and minimum general standard of living may be exempted from tax. On the other hand, a very high income may be taxed at a higher rate and it may also be subject to additional taxes like surcharge.
Similarly, an expenditure tax of progressive nature, too, will cause a reduction in inequalities to some extent. Further, concentration of wealth and power in a few hands can be minimised by a progressive type of general property tax and net annual wealth tax. Similarly, direct tax like capital gains tax is apparently progressive in nature, as it greatly helps in minimising the gap of inequality in the distribution of income and wealth.
Above all, the transfer of wealth upon death is a point at which progressive taxation may achieve desirable effects. A progressive inheritance tax or death duty will help not only in reducing the inequalities of wealth but also the inequalities of incomes generated through wealth.
In the interest of equity, however, progressive inheritance tax may be devised by assessing it on a progressive scale on the amounts inherited by different heirs. Mill, in this context, suggested that there must be a fixed minimum sum beyond which no individual could inherit. But here a complication might arise.
When a person inherits on different occasions, he will be taxed less heavily. So it is thought that it is better if an inheritance tax is graded, not only according to the amounts of inheritance received, but also according to the amount already possessed by the heirs. A loophole generally found in death duty is to avoid it by making gifts in contemplation of death. To check this tendency, a gift tax may also be evolved:
In short, from the foregoing discussion, it follows that a progressive tax system is an important means to reduce inequalities in income and wealth. Dalton, as an empirical measure of the ‘degree of progressiveness’ in a tax, however, suggests that if a rate of tax t is imposed upon a given income y, the progressiveness of tax may be measured by (dt/dy).
That is to say, the degree of progressiveness of tax is measured by the ratio of relative change in tax rate to a change in income, i.e., dt/dy. Evidently, if dt/dy is positive, taxation is said to be progressive. If dt/dy is zero, taxation is proportional and if dt/dy is negative, taxation is regressive. The formula, however, measures progressiveness only at a given point on the tax scale, and not on the tax scale as a whole.
For measuring the degree of progressiveness of a tax system as a whole, Dalton evolved a formula as under:
P = d – (d’ + a)
Where p stands for the degree of progressiveness;
d stands for the range of inequality of incomes before tax payment;
d’ stands for the range of inequality of net disposable income, after tax payment;
a is the value of positive constant relating to the allowance made for some increase in inequalities on account of regressive, proportional and even regressive nature of the tax system.
According to this formula, inequality would diminish only if P is positive as well as greater than a. It also suggests that in a modern tax system which is composed of direct and indirect taxes, there are elements of progressiveness as well as regressiveness all at the same time, but the regressive element of some taxes may be more than offset by the progressive element of other taxes making the tax system as a whole progressive, which alone can help in reducing the inequalities of income and wealth in the community.
However, unduly high progressive taxes adversely affect production; therefore, equitable distribution should not be aimed at the cost of economic growth and prosperity.
Further, the distribution of income is also affected by the different kinds of taxes. Progressive income tax, wealth tax, estate duties, etc. ensure equitable distribution, while commodity taxes on essential goods will have a regressive effect which will have an unfavourable impact on distribution.
There is, however, always a dilemma in the matter of a choice between distribution and production. In a developing economy, effects of taxation on production and distribution should be reconciled.
Taxes should be made progressive to ensure equitable distribution, but progressivity should not be so sharp as to adversely affect production and growth. Indeed, in a developing economy, distribution must follow production. There should be economic planning for production and appropriate fiscal measures for equitable distribution, once the production goal is realised.