In this article, you will be able to know about the taxation, types of taxation, methods and theories of taxation, and economic impacts of taxation.
1. Introduction to Taxation
It is a prime responsibility of a government to fulfil and maintain the objective of macroeconomic stabilization like maintaining price and exchange rate stability, providing employment; achieving and maintaining faster economic growth etc. government do this by using two types of policies viz. monetary policy and fiscal policy. Monetary policy refers to managing the money supply and credit control, while fiscal policy refers to managing public expenditure and taxation.
Taxation is a part of fiscal policy and necessary to maintain public expenditure. Taxes are compulsory payments made by the various entities for using the goods and services provided by the country or government. There are two essential features of taxation. The first one is, it is a compulsory payment and the second one is, it is used for the purpose of gaining welfare in the economy.
Taxes in India are levied by all three types of governance central government, state government and local authorities. The imposition of taxes by different government is divided by the provision of the constitution of India article 264 to article 300. These articles include all the provisions relating to the financial relationship between the state and central government. Although the Indian government implemented a single tax regime known as Goods and Services Tax (GST) in 2017, still, there are multiple types of taxes prevailing in India.
Tax revenue comprises a greater proportion of total revenue of the government of India. However, its contribution to GDP is still very low. In 2017-18 the tax to GDP ratio was 7.26 per cent, but only 2-3 per cent of the population comes under the net of income tax. The Indian tax structure is often considered as a complicated tax system and tax evasion is also an important problem in the Indian tax structure.
A tax system comes with certain objectives. Some of the common objectives that a tax system tries to fulfil are given below.
- Taxes are levied to raise the required funds to meet its public expenditure.
- Taxes augment private savings by restricting the private consumption expenditure by an individual.
- Taxes redistribute income in society and reduce inequality.
- Taxation often mobilizes the resources in an economy so that, economic development could be an impulse.
- Taxation is also an important tool to stabilize the cyclical fluctuations in the economy
- Taxes also try to correct the balance of payment difficulties.
2. Classification or Types of Taxation
Taxes are classified as direct and indirect taxes, ad-valorem and specific taxes on the basis of types of taxation. However, on the basis of the method of taxation, it can be classified as progressive, regressive and proportional taxes.
- Direct and Indirect Tax
Direct tax refers to the tax that has incidence and impact of taxation on the same person. Here incidence of taxation means the event of the imposition of tax on something or someone, while the impact of taxation means actual felling of taxation and refers to the point where the burden of taxation is actually felt. Thus, a direct tax is involuntarily payment paid by the entity on which it is imposed. Direct tax is often considered as progressive in nature and its impact on the economy is not at all inflationary. Income tax, Corporation Tax and Wealth tax are some examples of direct tax.
Indirect tax refers to the tax that has incidence and impact of the taxation on the different person. It means the actual person who is imposed need not pay the tax; he can avoid or transfer it to another person. Indirect tax is regressive in nature and its impact on the economy is inflationary. VAT, Excise duty and GST are some examples of indirect tax.
- Ad-Valorem and Specific Tax
When the imposition of the tax is based on the value of a product, it is known as ad-valorem tax. It is imposed on the value of the product not the quantity of the product. Ad-Valorem tax is progressive in nature. This tax is expressed in percentage term like some percentage of the value of the product.
When the imposition of the tax is based on the quantity of a product, it is known as a specific tax. It is imposed on the quantity of the product and is regressive in nature. This tax is expressed in a specific sum.
- Progressive, Regressive and Proportional tax
On the basis of methods of taxation, there are three types of taxes.
When the tax rate on income increases with an increase in the level of income, it is called progressive taxation. In this taxation poorer have to pay a lower proportion of income as tax; while richer have to pay a higher proportion of income as tax.
When the tax rate on income decreases with an increase in the level of income, it is called regressive taxation. Here poorer have to pay a higher proportion of income as tax, while richer have to pay a lower proportion of income as tax.
When the tax rate on income remains constant across the different levels of income, it is called proportional taxation. In the case of this taxation, poorer and richer both have to pay an equal proportion of income as tax.
3. Theories of Taxation
To achieve justice and equity in taxation, various theories and principles of taxation have been developed from time to time.
- Benefit Theory
According to benefit theory of taxation, the level of taxation on an individual should be according to the level of benefits received by that individual from different government goods and services.
However, this theory has been criticized on various grounds like a violation of compulsory payment principle and government makes expenditure on for general benefits, not individual.
- The Cost of Service Theory
This is a widely applied theory of taxation that also ensures the idea of equity and justice in taxation. According to this theory, the actual cost of services should be taxed from the people. The drawback of this theory is that cost of some services like police, armed forces etc cannot be determined.
- Ability to Pay Theory
This theory suggests that taxation should be imposed on an individual on the basis of his or her ability to pay. This is the most popular theory of taxation which fulfil the principle of equity and justice. According to this theory, tax can be levied on the basis of ownership of property and level of expenditure or income by an individual.
- Proportionate Principle
J. S. Mill and other classical economists suggest the idea of equal sacrifice with proportionate taxation on different levels of income. However, modern economists don’t consider it as fair and just as marginal utility of income decreases with increasing level of income.
4. Economic Impacts of Taxation
Taxation has both positive and negative effects on almost every sector of the economy. It has a larger impact on economy, society as well as governance. Taxation has a wider economic impact on production, consumption, employment, economic growth etc. in the following section, we will analyze the various economic impacts of taxation.
- Effects on Production and Growth
The imposition of taxation affects the level of production and growth in the economy. We can understand the effects of taxation on production via three broad approaches.
- Effects on ability to work, save and invest
The imposition of taxation affects the ability to work in various ways. One way is that when a direct tax is imposed, it instantly reduces the disposable income of the person and in turn restricts the person to consume such goods and services that can increase the efficiency. Another way is via indirect tax which increases the price of goods and services and in turn results in under consumption.
It also affects the ability to save by reducing disposable income in case of direct tax and increasing consumption expenditure in case of indirect tax. A progressive taxation method reduces the private savings of richer classes.
Taxation has both positive and negative effects on the ability to invest in the economy. One hand it increases the public investment by raising revenue of the government and on the other hand, it reduces the private investment by reducing the savings of investees.
- Effects on willingness to work, save and invest
The imposition of taxation also affects the psychology of a person. After the imposition of taxation, people feel a money burden and get disincentivized and reduce the level of effort to work, save and invest. It has also a different aspect that is related to the elasticity of demand for the income of an individual after imposition of taxation. If the elasticity of demand for income increases after imposition of taxation, individual will be more intended to work, save and invest. On the other hand, if the elasticity of demand for income decreases after the imposition of taxation, it will reduce the willingness to work, save and invest.
- Allocation of resources and taxation
If taxation is imposed on such goods and services that are not beneficial for the society then the effects of taxation will be beneficial for the production as it will change the allocation pattern of scarce productive resources towards the production of essential goods and services. On the other hand, if taxation is imposed on necessary goods and services, it will change the allocation pattern of scarce productive resources towards the production of undesirable goods and services and will result in harmful effects on production and economic growth.
- Effects of Taxation on Distribution of Income and Wealth
A taxation is an effective tool for redistribution of income in the society. It can reduce income inequality and can achieve the pursuit of distributional justice. However, it has both desirable and undesirable effects on the distribution of income and inequality.
If the taxation method is progressive then it will be fewer burdens for the lower-income people and richer will have to pay a higher tax. It will help in reducing the income and wealth inequality in society. It has also undesirable effect that it disincentivizes the higher income classes to work, save and invest.
If the taxation method is regressive or proportional then it will be fewer burdens for richer and more burdens for poorer classes. It will increase the income and wealth inequality in society.
Taxation on essential goods and services that are majorly consumed by mass common population can increase the inequality in the society, while taxation on conspicuous consumption can reduce inequality.
- Effects of Taxation on Supply of Factors of Production
Taxation also affects the supply of factors of production. If the supply of a factor is less elastic or fixed then its supply and price will be less affected by the imposition of taxation. On the other hand, if a factor of production is more elastic then its price and supply will be more affected by the imposition of taxation. The imposition of taxation affects both income effect and the substitution effect of the labour supply. The proportional tax on the income of the labour reduces the supply of labour equal to that proportion.
- Effects of Taxation on Consumers and Producers Surplus
The imposition of quantity tax on any commodity increases its price and reduces its supply and contracts its demand. Hence, it reduces both the consumers and producers surplus. However, which one will lose its surplus more depends on the elasticity of demand and supply curve of the market participants.
If the elasticity of demand for that commodity is less elastic then the burden of taxation will be more on consumers than producers. While, if the elasticity of supply for a commodity is less comparison to demand, taxation will be more burdens for the producers. Hence, the shifting of taxation on any commodity from producer to the consumer depends on the demand and supply of that commodity.
The figure shows that initially, the demand curve was DD and supply curve was SS and equilibrium point was E with equilibrium price P and quantity Q. after imposition of tax the price increased to P1 and the equilibrium point shifted to E1 new supply curve S1S1. Now the equilibrium quantity will be Q1. The loss in consumer surplus is triangle E1GE and loss in producer surplus is triangle LGE. The tax revenue to the government will be area P’P1E1L and the deadweight loss will be the sum of two triangles i.e. loss of consumers surplus and producers surplus. Deadweight loss is the loss of society due to taxation. Here, the shifting of taxation from producer to consumer will be greater if the elasticity of the supply curve will be larger. In that case, the producer will gain the revenue and consumer will pay the maximum part of the tax. If the supply curve will be perfectly elastic then producers will shift the 100 per cent of the burden of tax to the consumers. The reverse will happen in case of perfectly elastic demand curve as producers will pay the 100 per cent burden of the tax.
- Effects of Taxation on Price Level
Taxation raises the price level and cost of production. The quantity tax raises the price of a commodity proportionate to its tax rate generally. The other types of taxes on inputs raises the cost of production and hence, price level. However, lump-sum tax on the producers directly does not affect the price level so much but reduces the profitability of the produces and makes them less incentivized to invest more and more.
- Effects of Taxation on Financial Market
Many taxes are levied on the income generated from the financial market. It affects both individual investors and corporations. In case borrowing and lending a tax on the income generated by providing credit facility increases the lending and borrowing rates and affects both the lender and borrowers. A high-level corporate tax affects the income and behaviour of firms and investors. A firm prefers more loan if the corporate tax is higher as the loan provides a shield against the tax. It also affects the dividend policy of a firm.
- Effects of Taxation on International Trade
The imposition of taxation on exports and imports makes international trade difficult. It leads to an increase in the price of import if the government imposes a heavier custom duty on imported commodities. The government imposes different types of taxes on imported commodities. It discourages the importers and increases the price of that commodity in the domestic market. The imposition of taxation on exports makes the exports expensive and hence, raises the trade deficit in the balance of payments of a country. It also affects the international mobilizations of factors of production and reduces the foreign direct investment in the country.
- Effects of Taxation on Government Activities
The activities of the government are also affected by taxation. If the tax to GDP ratio is high then it can reduce the borrowings of the government and increase the level of public expenditure and investments. In other words, it promotes self-reliance. Taxation is one of the biggest sources of revenue of the government and it induces the government to undertake various projects that are very strategic to the development of the country.
- Laffer Curve
The laffer curve describes the relationship between different level of tax rates and the level of revenue generated by the taxation and introduced by the Aurthor Laffer in the year 1979. It basically says that tax revenue at 0 per cent tax rate will be zero and similarly the tax revenue will be zero if the government imposes 100 per cent tax rate. If the government raises the tax rate then up to a certain point the tax revenue will increase and at a particular tax rate (say t%) it will reach the maximum level of revenue and then if government further increases the tax rate it will lead to decrease in the tax revenue at finally will reach to zero tax revenue at 100 per cent tax rate.
After a discussion on the economic effects of taxation on various aspects of an economy, it can be concluded that taxation has both positive and negative impact on the economy. It has many favourable effects on the economy like it provides sufficient funds to the government to raise the level the public expenditure and welfare in the economy. It also works as a regulator and stabilizes the consumption and investment in the economy. Taxation is the best way to redistribute income in society and reduce inequality. However, it has many negative and unfavourable effects on the economy like it increases the price level, reduces the ability and willingness to work and investment. It also reduces disposable income with people and reduces savings. It also affects the international trade policy as making exports and imports more expensive.
Economic effects of taxation. Yourarticle library
Role and objective of taxation in a developing economy. Sodhganga inflibnet
Taxation in India. Wikipedia
The impact of taxation. Economic Help organization
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Author: Alok Aditya Central University of South Bihar
Author: Prabhat Kumar Central University of South Bihar