Impact of Taxation on the Economy

  

Date Posted: 8/4/2012 5:32:29 AM

Posted By: moff J  Membership Level: Silver  Total Points: 485

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Taxes are the major major means by which the government finances its activities. Therefore introduction of new taxes will surely increase the government revenue. However, one question that one has to ask is whether the taxes will be good for the economy as a whole.
In as much as taxes improve the government''s revenue, it also reduces the disposable income available to households for consumption.
Consumption is the biggest component of the GDP and therefore a reduction in consumption is likely to slow down economic growth.
Let us look at the impact of taxes on the economy of a country in details now.

Taxes, as mentioned earlier, reduce the disposable income of consumers. Disposable income is the income that households are left with after deducting taxes. Households have two uses for their disposable income, that is, consumption and saving. When their disposable income is reduced, both consumption and savings are automatically reduced.

In the national income determination, consumption by households represents the biggest component of the GDP. This implies that a reduction in consumption is likely to slow down economic growth.

Savings on the other hand supply the funds which are loaned to firms for investment. As mentioned earlier, taxes reduce the amounts available for saving. Hence, the funds available for loaning to firms are limited or are obtained at high costs which tends to discourage investors.
Investment is another component of the GDP. Reduction in investment means that the economic growth of a country is likely to be slowed down.

When you flip the shilling, taxes increases the revenues for the government which increases government spending. Government expenditure is also a component of the GDP and an increase in government expenditure may therefore signify an improvement in the economy of a country.

The question that we need to ask ourselves right now

is whether imposition of extra taxes is good for the economy or not? This brings to mind the concept of the multiplier effect.
The multiplier refers to the change in national income due to change in a component of the national income.
An analysis of the impact of taxes on the economy requires the use of the tax multiplier.
The effect of taxes on consumption is that it reduces consumption by the amount of taxes multiplied by the marginal propensity to consume (the amount consumed by the households per unit shilling).
It also reduces investment by the amount of taxes imposed multiplied by the marginal propensity to save (amount saved per unit shilling).
However, government expenditure increase by the amount of taxes levied.

The overall effect is that consumption and investments reduces more than government spending increases. This implies a decrease in the national income. The net decrease in national income may be gotten by obtaining the tax multiplier and the multiplying it by the amount of taxes levied.

In conclusion, imposition of extra taxes has negative impact on the economy. However, if the government expenditure multiplier effect exceeds the tax effect on consumption and investment, then it can simulate economic growth. A detailed analysis of the effect of taxation on the economy therefore has to be done before the government imposes new taxes on the economy.

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