Taxation

Taxation can be used to finance government expenditure or to service the national debt. It can also be used to promote welfare or to change the distribution of income or wealth, and it can have the unintended effect of reducing welfare. Its use as an instrument of fiscal policy is considered in a separate article on that subject.

The effects of taxation

Every combination of the various forms of taxation has a different effect upon welfare, but all of them have certain common features. In the terminology of economic theory, each of them has an income effect, and most of them have substitution effects. The income effect is the reduction in the resources available to taxpayers that is brought about by the transfer of resources to government. It occurs, therefore, without affecting the total of the country's resources. The substitution effect, on the other hand, may result in a reduction in the country's resources by bringing about a move to less productive activity. An increase in income tax may, for example, induce a skilled worker to reduce his working hours and spend more time on untaxed do-it-yourself activities. The resulting reduction in output would have the indirect effect of reducing national welfare. The substitution effect may alternatively have a direct effect of welfare by prompting taxpayers to buy products other than those that they would otherwise prefer. A tax on biscuits, for example, may prompt buyers to switch to an untaxed but less enjoyable product, such as bread. The size of the substitution effect depends upon the extent to which the tax varies with a level of activity (the marginal tax rate) and the responsiveness of the level of that activity to its price (the elasticity of supply or demand). Taxes that have no effect upon supply or demand, such as a land-value tax or a poll tax, have no substitution effect, and activities whose level is relatively insensitive to price (such as purchases of bread) have relatively small substitution effects.

A second common feature is the effect of taxation upon the distribution of income and wealth.