Higher Taxes Benefit the Economy

Taxes are an important part of how a government receives money in order to operate. Taxes are unique because, unlike other payments made by households and firms for goods and service, they are defined as “an involuntary payment of money (or goods and services) to a government by a household or firm for which the household or firm receives no good or service directly in return” (Brue, McConnell, & Flynn, 2010, p. 483). Taxes have a huge impact on how the economy operates in every nation. Lowering taxes can have some benefits but higher taxes give the most benefit to the economy.

Taxes are the foundation of government funding. Excluding social insurance premiums “income taxes— personal and corporate— account for seven out of every eight federal tax dollars. Individual income taxes alone provide nearly three-fourths of federal tax revenue” (Becker, 2002, p. 127). It is obvious that taxes will be a part of government regardless of ideology or political party. The question that faces governments today is how high should tax rates be allowed to climb.

Regardless of the type of tax those being taxed will find ways to work within any government imposed rate as explained in The Encyclopedia of Public Choice:

“Individual taxpayers will respond to tax rates by adjusting their activities so as to reduce their tax liability, with such adjustments being quite unrelated to the consumption of publicly provided goods. If an income tax is levied, for example, taxpayers may reduce work effort and consume more leisure, in order to maximize utility in the face of such taxation. This results in a reduction of economic welfare in comparison to a situation where payment for the same public output elicits no such trade-off or evasive adjustment. The size of this loss — the excess burden or deadweight cost of taxation — is used in the literature as a measure of the inefficiency created by a particular tax” (The political economy, 2010, n.p.).

When a government chooses to lower taxes it is usually in response to an economic downturn. Governments choose to use lower taxes as a stimulus for the economy. “The fiscal response to a recession is partly automatic (lower revenues and higher transfers as the economy shrinks) and partly discretionary (lower tax rates, infrastructure projects, extra help for states and so on)” (Column, 2011, n.p.). An automatic response to an economic downturn or recession is to lower taxes because it is viewed by politicians as what they should do to encourage recovery in the economy. The real benefit of their action of lowering taxes is not based on economic mechanics but encouraging faith in the strength of the system.

When taxes are lowered the effect on several parts of the economy are positive. Government spending is typically lower when taxes are lowered which can stimulate real growth in industry by its filling the void of what may have been spent by the government. Personal net income is positively affected by lower taxes when all other factors remain the same. If personal income remains the same and the tax rate on that income is lowered, the net amount taken home is increased.

Lower taxes encourage broader personal investment since there is more net income available to personal households. During the early 1980’s tax rates were lowered for those that had the ability to invest in the economy. The lower tax burden on investors had an immediate and clear result:

“The simplest and most direct interpretation of the evidence developed in the present paper is that net fixed nonresidential investment increased substantially in the first half of the 1980s as a result of the improved tax climate for investment that resulted from the 1981 tax legislation and from the reduced rate of inflation. The ratio of net fixed nonresidential investment to GNP rose from 0.027 in the second half of the 1970s and 0.030 in 1980 to 0.037 in 1984 and 0.040 in the first 3 quarters of 1985. The investment-GNP ratio for these 2 years was exceeded in only 5 years in the preceding 3 decades” (Feldstein, 2009, p. 114).

When a government chooses to raise taxes it is usually in response to a budget shortfall or spending increase. Governments have limited means of raising operating capital to satisfy monetary needs so they have a need for taxes. Politicians are constantly balancing between the need to generate revenue through taxes and their constituencies calling for lower taxes. Fiscal policy is controlled in the United States by elected officials which means they are always seeking to do what is best politically first and then what is economically best second.

When taxes are raised the effect on several parts of the economy are positive. Government spending is typically higher when taxes are raised which can stimulate government related growth and encourage private industry to match the spending pattern of the government. Personal net income can be positively affected by higher taxes although when all other factors remain the same personal net income will decline. If personal income remains the same and the tax rate on that income is raised, the net amount taken home is decreased therefore higher tax rates typically encourage households to increase the amount of income being made by the household.

One possible danger however of higher tax rates is that many will be forced to increase the amount of income coming into the house but may do so in a way that circumvents the tax system. When increases in tax rates force workers to avoid the tax system they may be forced into the underground economy. The underground economy creates challenges for governments since this culture fails to induce “people to work less and take more leisure, high taxes on labor income may motivate workers to go ‘‘underground’’ to work in the informal economy where taxes are evaded. Measuring the size of the underground economy is obviously difficult, but existing empirical studies suggest that it accounts for a significant share of total economic activity even in the most developed OECD countries” (Agell & Sorenson, 2006, p. 16).

Not only are taxes an important component for governments to raise revenue but are also used to control growth. The goal of fiscal policy is for the Gross Domestic Product to increase at all times. When the GDP is contracting or growth is slowed lowering taxes can encourage more growth. When the GDP is growing and inflation is increasing higher taxes may cause the slowed growth of the GDP.

Governments have long experimented with equalizing wealth among citizens. Political ideologies such as communism and socialism seek to limit personal wealth and distribute personal needs equally among the population. There are many pitfalls that occur when governments try to redistribute wealth among their citizens. “Many economists, at least since Adam Smith, have argued that taxes should not be used for nonrevenue purposes because these uses affect the distribution of tax burdens in complex ways and distort economic behavior in general. Nevertheless, most governments have always used taxes for nonrevenue purposes” (Einhorn, 2008, p. 19). Governments should not use fiscal or monetary policies to solve, or attempt to solve political or social issues.

Taxes are an important part of how a government receives money in order to operate. Taxes are doubtless going to be a part of government for as long as there is a monetary system. There has to be a policy in place to decide how high or low taxes should be to encourage economic growth. Lowering taxes can have some benefits but higher taxes give the most benefit to the economy by encouraging increased household income and stimulating governmental spending.

References

Agell, Jonas (Editor); Sørensen, Peter Birch (Editor). Tax Policy and Labor Market Performance. (2006) Cambridge, MA, USA: MIT Press. http://site.ebrary.com/lib/ashford/Doc?id=10173621&ppg=17

Becker, Patricia C.(2002). Bernan Press Staff. Statistical Portrait of the United States: Social Conditions and Trends (2nd Edition)

Brue, S. L., McConnell, C. R., & Flynn, S. M. (2010). Essentials of economics (2nd ed.). New York, New York: McGraw-Hill Primis Custom Publishing.

Column: A fiscal policy fit for the next crisis. (2011, June 27). Financial Express, retrieved July 31, 2011, from Banking Information Source. (Document ID: 2385525431).

Einhorn, Robin L.. (2008). American Taxation, American Slavery. Chicago, IL, USA: University of Chicago Press. http://site.ebrary.com/lib/ashford/Doc?id=10265931&ppg=19

Feldstein, Martin. Effects of Taxation on Capital Accumulation. (2009). Chicago, IL, USA: University of Chicago Press. http://site.ebrary.com/lib/ashford/Doc?id=10288679&ppg=114

“The Political Economy of Taxation: Positive and Normative Analysis When Collective Choice Matters.” The Encyclopedia of Public Choice. (2004). Dordrecht: Springer Science Business Media. Credo Reference. 3 Feb. 2010. Web. 1 Aug. 2011.

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