Taxes

There are few things people hate more than taxes. It ranks up there with death and annoying relatives. Unlike the latter, taxes do have an important use. They serve as a form of income distribution, passing wealth from the wealthy to the poor. Taxes are also used to fund government activities such as regulation and investment in public goods. Regulation is needed in situations where market failure exists. Market failure is any situation that prevents a market from delivering an outcome similar to that which would exist in a perfectly competitive market. Market failure does not mean that the market has failed, only that the equilibrium output produced is below that which would have been produced had the market been perfectly competitive. Public goods are goods that have at least one of two properties, non rivalry and non excludability. I will get into that on another post

Although taxes have an important use, they are also distortionary. This means that they have an effect on the amount of goods and services we demand. In the presence of taxes, less goods are demanded by consumers and less labor is supplied by workers (although lower labor supply might not always be the case). In economics, we are taught that lump sum taxes are better than proportional taxes. Lump sum taxes do not have an effect on the ratio between the amount of goods and services we demand. Proportional taxes on the other hand act as if there is an increase in the price of a commodity, in this case altering the price ratio between two or more goods (or labor and leisure).

Higher taxes have the effect of lowering a person’s disposable income, the amount of money they take home after taxes. The lower disposable income means that spending by that person has to go down, or saving has to fall or both fall. The reduced spending extends to everyone in the country that has been hit by the higher tax rates, as a result, spending goes down in the economy. With people spending less than they did before the taxes rise, businesses will now be faced with goods that are not being sold. This would not be the case if the tax rise was anticipated well in advance. If businesses did anticipate the tax rise, they would reduce production knowing that aggregate demand would be weaker. On the other hand, if the tax rise comes as a surprise or with little time for businesses to adjust, then inventory will pile up. With inventory pilling up, firms will demand less good from their suppliers, and the suppliers will demand less from theirs and so on and so forth. The end result of this process is that less goods and services will be produced than were before the increase in taxes. The lower production by firms means that profits will be down and costs have to be cut. The typical response from firms when faced with cost cutting is to lay off staff. Keeping the staff would lead to the firm having too many workers. This in turn leads to lower aggregate income and lower consumption which leads to lower aggregate demand.

There is an upside to lower aggregate demand although it might not be seen as that by firms. Lower aggregate demand means that firms will invest less in capital than before, which leads to lower costs of capital and lower interest rate from banks. It also means that price rises (inflation) will slow down. If the economy is faced with imported inflation, then lower aggregate demand will not reduce inflation.

Imported inflation refers to the rise in the price of goods and services that are imported. The rise in price of these goods means that even with a stable exchange rate, these goods will cost more to buy at home. If that good is an input to production, say oil, then the rise in price will affect any good that uses it as an input in production. The goods using that input should also see an increase in their price. This pushes up prices at home as well, since imported goods are part of the basket of goods that people will buy. The more open a country is, the more imports and exports make up a large portion of GDP, the larger the pass through of import price inflation to domestic prices.

If an economy, as mentioned above is faced with imported inflation, then the result will be lower aggregate demand, slower (or even negative) GDP growth and higher inflation eroding people’s income even more. If people are faced with this situation, assuming they are rational, they must adjust their preferences to the new conditions they face. With disposable income being less than it was, workers are faced with two options, either reducing work hours because work does not pay as much as it used to or finding other ways to met the shortfall in income.

The first option seems more likely when taxes are extremely high and inflation is fairly moderate. The latter option seems more like when taxes are fairly high, inflation also high and people think what they earn is not enough to meet their needs. For those whose income is proportional to the amount of time or effort they put into the work, working more hours will help to raise income to meet this short fall or keep up with rising prices. For those in business (small and medium), raising prices to increase profits is an option, although they can’t raise prices indiscriminately since they are faced with a weaker aggregate demand. Those who’s wages are fixed by contract have less options. Negotiating for higher wages in a slowing economy is very difficult even with inflationary pressures pushing down real wages. Being rational individuals, these people will seek to find ways of increasing their take home pay without directly asking for higher wages. Moonlighting or shirking at work to run “personal businesses” are just some of a few things they will do to maintain their take home income.

This shirking will mean that less time will be devoted to formal work and more time to informal activities that generate income. The end result will be more distortion in the labor market.