The Economic Effects of Taxation

However, despite these initiatives, Pakistan still faces some structural issues due to outdated tax policies, a cumbersome tax filing process, weak tax administrations, and low tax compliance. Having completed this general economic analysis of the effects of taxation, which today’s economic textbook writers typically prefer not to deal with at all, let me now turn to what they typically do say about the effects of taxation under the heading of tax-incidence. In light of our previous analysis it will be easy to detect the fatal flaw in such accounts. Indeed, that one should fall headlong into error in dealing with specifics if one has not bothered to study the basics can hardly come as a complete surprise. In light of this general explanation, I will then demonstrate the fundamental logical fallacy in the standard textbook analysis of tax-incidence.

Reducing that marginal tax rate raises the after-tax wage, which can encourage the person to work more (the “substitution effect”). At the same time, however, the higher after-tax wage means the person can work fewer hours and take home the same after-tax income. People typically spend some of the additional income, raising demand for goods and services. Tax policy can also change firms’ cash flow or incentives to invest and consequently alter demand for investment goods.

How do financing methods affect the distributional analyses of tax cuts?

Workers may choose to save in tax-advantaged vehicles such as employer-sponsored 401(k) plans and Individual Retirement Accounts (IRAs). People also have choices among post-tax Roth versions of 401(k), 403(b), and 457(b) accounts. Studies have shown that Roth accounts are more valuable for risk-averse workers if the future tax rates are uncertain because the post-tax accounts help them lock in the current known tax rate 31. On the other hand, the existing tax rate schedules are progressive, which incentivize people to choose the pre-tax accounts like the traditional 401(k) plans. This is because most people expect their income to be lower in retirement than in working age, so it’s cost-effective to contribute tax-free money while working and pay taxes when withdrawing.

  • Having said that, additional evidence does seem to suggest that the reduction of top marginal income tax rates has been one of the ingredients contributing to lower effective tax rates for the rich.
  • Capital gain is generally a gain on sale of capital assets—that is, those assets not held for sale in the ordinary course of business.
  • At a minimum, it’s best to be prepared for the transparent and consistent reporting that will likely be required in all aspects of business.

In the policy world, these controversies have heated up in recent years as several states, hoping to stimulate long-term growth and new business activity, have cut taxes in various ways as their budgets have recovered following the Great Recession. A value-added tax (VAT), also known as Goods and Services Tax (G.S.T), Single Business Tax, or Turnover Tax in some countries, applies the equivalent of a sales tax to every operation that creates value. That manufacturer will pay the VAT on the purchase price, remitting that amount to the government. The manufacturer will then transform the steel into a machine, selling the machine for a higher price to a wholesale distributor. The manufacturer will collect the VAT on the higher price but will remit to the government only the excess related to the “value-added” (the price over the cost of the sheet steel).

( Effect on the capacity to work, save and invest

Here we want to provide more detail regarding different forms of ‘commodity taxation’, in particular consumption taxes. A similar chart showing marginal and average rates for the income of single individuals – as opposed to married couples filing jointly – can be found here. Roughly speaking, governments finance policy from taxes, grants (typically in the form of ‘development assistance’ transfers), and debt (more precisely budget deficits, or reductions of budget surpluses). As we can see, the relative importance of income tax within government budgets fluctuates with time, but there is a clear positive trend in most cases. Two distinct concepts of taxation are horizontal equity and vertical equity.

Separate efficiency from social judgments and be honest about it

Reducing marginal tax rates on business income can cause some companies to invest domestically rather than abroad. Tax breaks for research can encourage the creation of new ideas that spill over to help the broader economy. The National Bureau of Economic Research studies the persistent effects of temporary changes in U.S. federal corporate and personal income tax rates. According to their recent 2022 working paper, a corporate income tax cut leads to a sustained increase in GDP and productivity. In contrast, personal income tax cuts trigger a short-lived boost to GDP, productivity, and hours worked but have no long-term effects. Tax policy also affects the economy through its effect on the government’s budget deficit.

Let’s freeze more than chump change

A similar argument can be made if the tax is levied on consumers, since in a market economy the tax will lower demand, and this will have a consequence also for producers. During the 19th century the prevalent idea was that taxes should serve mainly to finance the government. In earlier times, and again today, governments have utilized taxation for other than merely fiscal purposes. One useful way to view the purpose of taxation, attributable to American economist Richard A. Musgrave, is to distinguish between objectives of resource allocation, income redistribution, and economic stability.

Increased economic welfare

This expansion could be an increase in the annual growth rate, a one-time increase in the size of the economy that does not affect the future growth rate but puts the economy on a higher growth path, or both. Our focus on the supply side of the economy in the long run is in contrast to the short-term phenomenon, also called “economic growth,” by which a boost in aggregate demand, in a slack economy, can raise GDP and help align actual GDP with potential GDP. Tax cuts can also slow long-run economic growth by increasing budget deficits.

Another thing to consider is that fiscal externalities may occur over time, as people retime their incomes as much as possible to reduce tax liabilities. For instance, adjustments that allowed people to avoid certain tax changes using capital gains realizations (Auerbach 1988) [7] and stock option realizations were very widespread around the TRA 86 (Goolsbee 2000 [8]). Short-run responses may be very different from long-run responses and it may take a long time before policymakers can see and measure all the effects a given tax change truly had. I will focus most of this discussion on capital income, such as corporate earnings, capital gains, dividends, bequests, and wealth income. But the principles I lay out apply to labor income or to income from any particular capital asset, such as housing, bonds, or equity (if the tax system is differentiated by different capital assets as is often the case).


This fact can be used as the basis for practical or moral arguments in favor of tax simplification (such as the FairTax or OneTax, and some flat tax proposals). Depending on how quantities supplied and demanded to vary with price (the “elasticities” of supply and demand), a tax can be absorbed by the seller (in the form of lower pre-tax prices), or by the buyer (in the form of higher post-tax prices). If the elasticity of supply is low, more of the tax will be paid by the supplier. If the elasticity of demand is low, more will be paid by the customer; and, contrariwise for the cases where those elasticities are high. The meaning of these terms can vary in different contexts, which can sometimes lead to confusion.

That higher output would imply greater taxable incomes, meaning that the same average rates would raise more revenue. Section VI discusses the results from the literature on simulation models, which has generated two main results. First, debt-financed tax cuts will tend to boost short-term growth (as in standard Keynesian models and in the literature using the narrative approach), but also tend to reduce long-term growth, if they are financed eventually by higher taxes. Second, revenue-neutral income tax reform can provide a modest boost to economic growth. We find that, while there is no doubt that tax policy can influence economic choices, it is by no means obvious, on an ex ante basis, that tax rate cuts will ultimately lead to a larger economy in the long run.

This policy brief reviews how tax policies impact individuals and businesses, using some examples from major tax reforms in the last several decades. Taxation affects individual and family decisions on work, savings, and their choice of residence. In addition, tax policies influence how entrepreneurs organize their companies and optimize investment and borrowing activities. Moreover, tax codes affect the global competitiveness of the U.S. in attracting and keeping multinational companies. As discussed above, economic theories and models can help policymakers calibrate policy changes to achieve desired outcomes.

If employees fully absorb the payroll tax costs, then employers’ labor demand won’t change, but wages will fall. Indirect effects can supplement or offset the direct effects of tax policy on demand. For example, increased spending by people getting tax cuts becomes income for others, who in turn increase their spending.

Cross-country differences in tax revenues are linked to the capacity of countries to implement efficient tax collection systems. Here we provide evidence suggesting that political factors – such as the extent of institutionalized constraints on the decision-making powers of policy makers – help shape the level and evolution of fiscal capacity of countries. As we can see from the most recent data, at one extreme of the spectrum we have countries such as Cuba, France, Denmark, Norway and Sweden, where total tax revenues are higher than 30%. And at the other extreme, we have countries such as Libya and Saudi Arabia, where taxes account for less than 2% of national income.