Effects of Taxes

Why are taxes so important? What are the implications of taxes for the overall economy? How do taxes impact our saving accounts? Would a decrease in taxes bring more people to the labor market? You will be able to answer all these questions once you read our explanation of the Effects of Taxes.

Effects of Taxes on Economy

The effects of taxes on the economy are significant, and as such, the government is careful in designing tax policies that follow what's needed for economic growth. The tax individuals and households pay is determined by the government. It is one of the main tools in the government's hands to help achieve macroeconomic goals such as price stability and economic growth.

The government uses taxes to indirectly affect aggregate demand, the total demand for goods and services in the economy. Now, aggregate demand is crucial because a drop in aggregate demand would cause a recession in the economy. Additionally, a considerable increase would translate into a significant increase in the price level. Luckily, in both cases, the government can use taxes to influence aggregate demand and bring the economy to equilibrium. To find out more about taxes and how the government uses them, check out our article on Fiscal Policy.

The government may influence the amount of a family's disposable income by raising or lowering the rates at which they are taxed (after-tax income).

The quantity of money a consumer has available to spend is the primary element that drives consumer demand, which accounts for two-thirds of overall demand. This will cause shifts in aggregate demand, which will affect the overall economy.

We've stated that taxes indirectly affect aggregate demand by affecting the level of disposable income for consumers. Figure 1 shows three different levels of aggregate demand (AD) and how they interact with short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS) when there is a change in the tax rate.

Fig 1. - Effects of Taxes on Economy

When the tax rate decreases, the aggregate demand curve shifts to the right (from AD₁ to AD₂), increasing the total output produced (from Y₁ to Y₂) and the price level (from P₁ to P₂). As total output produced increases, the unemployment rate decreases as more workers are required to produce more.

On the other hand, an increase in the tax rate would lower the disposable income of households; this, in turn, would shift the aggregate demand curve to the left (from AD₁ to AD₃). As a result, the total output would drop (from Y₁ to Y₃), and the price level would drop (from P₁ to P₃). As output drops, the unemployment in the economy will increase.

The impact of a tax largely depends on the elasticity of the market being taxed. For example, an increase in tax on city water will not change consumers' behavior that much because consumers require water for drinking, cooking, and bathroom activities. This makes the tax quite effective, as it isn't likely to hurt demand. Alternatively, if a tax is placed on a highly elastic good such as Taco Bell, the effect on the market will be bigger, as demand will drop more than in the case of an inelastic good.

Effect of Taxes on Supply and Demand

Below is a graphical representation of a market under heavy taxation; this limits the supply and demand for the goods. The reduction of profit discourages producers from supplying more goods, and producers pass on some of the tax to consumers, decreasing demand.

• CS=Consumer Surplus: a customer's excess value by buying at the equilibrium price.
• PS=Producer Surplus: the excess value producers get for selling up to the equilibrium price.
• DWL=Dead Weight Loss: the lost efficiency from disruptions in the free market.

In the graph below in figure 1, we see a market previously at equilibrium that had a tax implemented on it. Without a tax, all highlighted areas belong to either a consumer or producer surplus. We can see that the tax severely limits consumer and producer surplus.

Fig 2. - Tax Revenue Illustrated Model

Very important to note that not all lost surplus is collected as tax; deadweight loss occurs due to a decrease from the equilibrium quantity. This creates an inefficiency in the market, as both suppliers and consumers would be better off at equilibrium.

To better understand this graph, let's put a relatable example to what it demonstrates.

Consider the market for Cherry Pull 'n' Peel Twizzlers:

Try your best to imagine an evil government that hates happiness, and wants no one to enjoy Twizzlers, so they put a $4 tax on every package of cherry-pull 'n' peel Twizzlers.

Effects of Taxes on Savings

There are two types of savings in an economy, private savings and national savings. Private savings refer to individual savings, whereas national savings refer to the government's budget and how much it has to save at the end of a fiscal year.

In its most basic form, saving refers to the part of the income that is not consumed. As tax directly impacts the income one receives, it will also impact how much one is capable of saving.

Private savings

Let's consider the effects of taxes on private savings. Let's first consider what happens when there is a tax cut. You receive a specific salary every month, and part of your salary goes to the government through taxes, the other amount that's left, you either consume or save it.

Now, most people have a specific ratio of consumption and saving; some of them may consume 80% of their income and save 20%, whereas others may consume 40% and save 60%; that entirely depends on which circumstances one is in. In either case, when there is a tax reduction, the individual has more income. So whether they save 20% or 60%, the amount of personal savings will increase.

On the other hand, an increase in taxes would shrink the income one receives as they'd have to pay more taxes, thus receiving less income. As such, the amount of their savings would decrease.

National saving

Taxes provide the main source of government revenue, which it uses to spend on different projects in the economy. Government spending is intrinsically linked to tax revenue and is one of the main components of the aggregate demand curve. As such, taxes have an important implication for national savings and the overall economy.

When the government decides to reduce taxes, there is less national saving in the economy as the government's revenue decreases. This could mean that the government would have to spend less as it's receiving less revenue or keep the same rate of government spending but finance it with increased taxes in the future. As such, a reduction in taxes will lower national savings in the short run.

On the other hand, increasing taxes means that the government has more money to spend, which causes national savings to increase.

Effects of Taxes on Production

To consider the effects of taxes on production, we'd have to consider both parties involved in the transaction, the buyer and the seller. The tax effect level caused by the tax is not contingent on whether the state receives the income from the producer or the consumer; instead, it relies on the price elasticity of both supply and demand.

Inelastic supply and elastic demand

Because there is some elasticity in demand, the customer is particularly price-sensitive. A relatively little rise in cost will considerably reduce the number of goods or services required. The introduction of the tax leads to an increase in the price on the market and a reduction in the desired quantity, which hurts producers and consumers.

Because of the inelastic nature of the supply in this scenario, the business will continue to produce the same amount regardless of the price.

Because of the inelasticity of manufacturing, there is a substantial degree of variations to be made in sales. Because the producer cannot transfer the tax onto the customer, the financial burden of the tax is instead borne by the producer. However, due to the additional input cost, marginal revenue is lowered, so production drops in response to the tax introduction.

Supply that is elastic, but demand that is inelastic

In some cases, consumption is inelastic, which means that the customer will consume a certain quantity of goods and services regardless of the price. The manufacturer will be able to keep producing the same amount of the item, but they will be able to raise the price by the amount of the tax. As a direct consequence of this, the buyer will be responsible for paying the total amount of the tax. The production in this scenario will not change. However, consumers will experience a decrease in purchasing power.

Effects of Taxes on Labor Supply

In the near term, tax policy impacts the availability of workers. It's possible that lowering payroll taxes will encourage more people to enter the workforce or encourage those currently employed to work longer hours. Changes in the supply have little impact on production when the economy is performing much below its potential level. Even if they desire more jobs, they will have difficulty obtaining them if the circumstances remain as they are. On the other hand, if the economy is performing at or near its capacity, the labor supply may increase production.