Dalton discusses the economic effect of taxation under the following three heads: 1. Effect of Taxation on Production, 2. Effect of Taxation on Distribution 3. Other Effects.
1. Effect of Taxation on Production:
According to Dalton effect of taxation on production can be in the following three ways:
(a) Effect on ability to work, save and invest.
(b) Effect upon willingness to work, save and invest.
(c) Effect of taxation on composition or pattern of production, i.e., on allocation of resources as between different uses.
(a) Effect of Taxation on Ability to Work, Save and Invest:
Any person’s ability to work will be reduced by taxation, which in turn reduces his efficiency. Taxation leads to reduction of purchasing power of taxpayers, thereby reduced income and consumption. Ultimately it leads to reduced ability to acquire the necessaries of life.
If the tax burden falls on the poorer sections, it reduces the consumption of necessaries and comforts of the poor class. Eventually it leads to lower efficiency and reduced ability to work of the poor class.
However, if the tax burden falls on richer income group, having surplus income, their ability to work and efficiency will not be affected. It will leave the consumption of necessaries and comforts unaffected and curtail only luxurious consumption of the richer income group.
However, Dalton points out that the effect of taxation on ability to work depends upon the nature and kind of tax. There are some particular types of tax, which promote ability to work. For example, taxes on liquor, opium intoxicating drugs etc. will help to curtail its consumption. This in turn will increase the ability to work of individuals. Hence, a tax on these goods has favorable effect on ability to work and save.
Saving is determined by income. When income is reduced by taxation, saving will also decline. Hence, ability to save is always reduced by all taxes. Progressive taxation reduces the ability to save of the richer income group, who have high propensity to save.
Taxes falling on the poor have no adverse effect upon their ability to save because they have very little propensity to save.
Ability to invest depends upon saving. If ability to save in adversely affected by taxation, automatically ability to invest will be reduced.
(b) Effect of Taxation on Willingness to Work, Save and Investment:
Taxation affects the willingness to work, save and invest and thereby the productive process in an economy.
Effect of taxation on willingness to work save and invest depend upon:
(i) Nature of tax, and
(ii) Psychological reaction of the taxpayer.
(i) Nature of Tax:
The objective of taxation is to induce the people to work hard and to earn more. But effect of taxation differs depending upon the nature of tax. In a tax system, there will be different kinds of taxes. Some may produce favourable effect, where some other may have harmful effects.
For example, a tax on windfalls, inheritance tax, special assessment, tax on monopoly profit etc. will not badly affect the willingness to work, save and invest. These types of taxes fall upon the unearned or unexpected income of a person. Hence, have no unfavourable effect.
Likewise a reasonable tax on commodities (excise duty, sales tax) will not have any bad effect on the willingness to work, save and invest. But if a large portion of income is taken away by way of commodity taxation, then it will affect saving and investment process in an economy.
Personal income tax will adversely affect the willingness to work, save and invest. Heavy burden of income tax will discourage the incentive to work hard and to earn more. Whereas import duties have got favourable effect. It will encourage the production of imported goods indigenously.
Likewise, expenditure tax produces favourable effect upon desire to work saves and invest. Progressive expenditure tax help to curb wasteful expenditure and encourage saving and investment. Hence, it is clear that different taxes have different effect upon willingness to work, save and invest.
(ii) Psychological Reaction of Taxpayer:
Prof. A.C. Pigou refer this as the announcement effect of taxation when a tax is imposed, the taxpayer feels that his income is reduced immediately. This psychology of the taxpayer will affect his desire to work, save and invest. This disincentive effect of a tax on the taxpayer’s willingness to work, save and invest is called the announcement effect of taxation.
However, this differs from person to person depending upon the elasticity of demand for income. The demand for income may be elastic, inelastic or unity. The demand for income is elastic if a person is not willing to work hard to maintain the same level of income, which has been reduced due to the imposition of tax.
In such case his desire to work and save will be reduced by the imposition of a tax. On the other hand, taxpayers demand for income is regarded as inelastic, his desire to maintain a given level of income is high, and he is willing to work more to maintain the level of income, which has been reduced by the imposition of tax.
In this case, his desire to work and save will be increased after the imposition of the tax. The demand for income will be unity, if the desire to work and save remains the same after the imposition of tax.
Apart from this, there are some other factors which influence the psychology of the taxpayers. During periods of boom, the profit margin will be high. A wave of optimism will be prevailing in the business activities.
Hence, a tax imposed during this period, will not badly affect the psychology of the taxpayer. It will not adversely affect their willingness to work and save.
During periods of war also taxation will not adversely affect the investor’s willingness to work and save. Industries which are well established and earning huge profit, will be in a position to bear the additional burden of taxation.
However, industries which are just commissioned and in infant stage, cannot bear the burden of taxation. Rather such industries require incentives like tax holiday, tax concessions etc. Hence, heavy burden of taxation will adversely affect the production of newly started industries.
(c) Effect of Taxation on Composition of Production:
In an economy volume of production depend upon ability and desire to work and save. However, composition of production depends upon allocation of resources. Taxation can be used as an effective instrument to bring optimum allocation of resources between different industries and regions.
Diversion of resources can take place from taxed industry to non-taxed industries. If the product of a particular industry is taxed, its price will increase and consequently demand will fall. As a result, profit margin will decline.
Ultimately this will lead to diversion of resources from this taxed industry to non-taxed industry. However, the diversion of resources from taxed industry to non-taxed industry depends upon elasticity of demand and supply of the products of such industries.
Taxation brings about a large variety of diversion of resources. Some diversion of resources are beneficial where as there are harmful diversion also:
(i) Beneficial Diversion:
Taxation result in the diversion of resources from occupation and places. This diversion may be favourable or unfavourable.
Taxation on commodities which are injurious to health like tobacco, harmful drugs, liquors, opium etc. will discourage their production. Consumption of such commodities will be discouraged because of a rise in price of such commodities.
When consumption and production of these commodities shrinks, it will result in the transfer of resources (labour and capital) from these type of productive activities, to the production of essential and useful articles.
Moreover, this will result in the reduced consumption of these harmful commodities and help to preserve the health and efficiency of the consumers. Hence, a tax on these types of commodities is socially desirable. Imposition of a highly progressive tax on luxury commodities, help to transfer resources from its production to essential commodities.
(ii) Harmful Diversion:
Taxation can result in harmful diversion also. Taxes on articles of mass consumption are not desirable. Such a situation will result in a harmful diversion of resources. For instance, when taxes are imposed on mass consumption goods, its price will increase, demand and consumption will fail and production will be curtailed.
As a result resource will get diverted from these industries to the production of less useful goods. Likewise when consumption of necessaries decreases due to taxation, it will adversely affect the health of the people and ultimately reduce their efficiency to work.
(iii) Diversion of Resources from Present to Future Use:
Taxes can be used to preserve the scarce but valuable resources for the future generation. Taxation help to shift resources from the present use to future use. Sometimes, taxes are imposed to discourage the excess consumption of certain type of goods and to preserve the limited resources for the future generation.
For example, for the preservation of scarce oil resources for the future generation, the government may impose high taxes on crude oil and even oil products. This will reduce demand and consumption of oil and petroleum products and will reduce production of crude oil. Thereby scarce oil resources can be preserved for the use of future generation.
(iv) Regional Diversion of Resources:
In a federation taxation can be used to divert resources from state to state depending on the political system. Different states follow different types of taxes. Taxable capacity of state may be different. Hence taxation can be used to divert resources form state where tax burden is heavy to states where tax burden is riot so heavy.
Diversion may take place from country to country. Entrepreneurs will invest in those countries where tax burden is low. So they will try to shift their resource investments form countries where tax burden is high to countries where the burden is low.
Government may give concession and tax exemptions to commodities produced by industries located in economically backward areas. This is done to attract resources and industries from overcrowded areas to less developed areas. Moreover, tax holidays will be given to new investments coming up in these backward areas, for attaining balanced regional development.
2. Effect of Taxation on Distribution:
In modern welfare state, tax is considered as the most important fiscal tool to achieve social justice by reducing glaring inequality existing in the distribution of income. The German economist Adolf Wagner, insisted that taxation should be used as an instrument to reduce inequalities in the distribution of income.
In this context Prof. Dalton observed “other things being equal, one tax system is preferable to another, if it has a stronger tendency to check inequality”. The effect of taxation on distribution of income and wealth, among different sections of society depends upon nature of taxation or rate of taxation and kinds of tax.
(a) Nature of Taxes or Tax Rate and Distribution:
Nature of taxation implies the distribution of tax burden among different sections of the community. By nature of taxation we mean whether It is proportional, progressive or regressive taxation. A regressive tax falls more heavily upon the poor community. It widens the gap between rich and poor. Hence, if regressive taxation is followed, inequalities in the distribution of income will increase.
On the other hand, progressive taxation helps to reduce inequalities in the distribution of income. Under progressive taxation, the burden of taxation falls more heavily upon the richer sections of the community.
Hence, progressive taxation is desirable to attain distributional justice. However, progressive taxation should be based upon the principle of ability to pay. Under proportional taxation inequalities will remain as such, if income remains the same. But if income increases in unequal proportion, inequality will increase.
The above analysis clearly shows that, equitable distribution of income and wealth, necessitate a sharply progressive taxation. Logically, equitable distribution aims at taxing the largest income and all incomes above certain level, should be brought under taxation.
As Prof. Edge-worth puts it “thus all incomes above, say Rs. 15,000/- a year would be reduced by taxation to that figure and no one whose income was less than this, would not be taxed at all”.
It implies as Dalton puts it “cutting of the heads of all the tallest poppies”. However, a system of progressive taxation can bring about desired distributional change in income and wealth.
(b) Kinds of Taxes and Distribution:
The composition of the tax system affects the distribution of income and wealth. Different taxes produce different effect upon distribution process.
Indirect tax on commodities generates more burdens upon the poor class. Taxes on mass consumption goods, consumed by the poor class, have regressive effect upon income distribution.
Hence, if possible mass consumption goods like food stuffs should be avoided from taxation. However, commodity taxation can be made progressive by imposing higher rate of articles of luxury consumption and leaving mass consumption good un-taxed or little taxed. Import duties can produce favourable distribution effect.
Direct taxes which fall on richer income group can also produce good distributional effect. Progressive income tax rates, while exempting a minimum level of income, have positive distributional effect. Likewise, property tax, inheritance tax, etc. also can make favourable effect on distribution of income and wealth.
3. Other Effects of Taxation:
Under this category, we study the effect of taxation on employment and regulatory effect of taxation.
(a) Taxation and Employment:
The major objective of taxation is to maintain economic stability. Prof. A.P. Lemer states that taxation should be instrumental in controlling economic activity. Taxation reduces purchasing power in the hands of the people and reduces their spending and consumption. As a result effective demand for goods and services decline and this lead to low level of economic activity and employment.
On the other hand decrease in tax lead to increased consumption and increased economic activity. This will create positive impact on employment front. Hence, taxation which decrease general level of consumption and increase saving will tend to reduce business activity and employment in developed countries.
Whereas taxation which discourages saving and investment will tend to reduce business activity and employment in developing countries.
(b) Taxation can be Effectively Used to curb business Fluctuations in the Economy:
The objective of taxation during inflation should be to reduce excess purchasing power in the hands of the people. Hence, a rise in the rate of existing taxation and imposition of new taxes during inflation will help to take away the excess purchasing power in the hands of the people. This will also help to check consumption and to decrease the level of effective demand. Therefore, this will help to bring price stability.
On the other hand, a reduction in taxation during depression helps to increase the level of economic activity and employment. During depression the revenue mobilized through taxation should be utilized for the creation of development activities which are employment generating and income generating in character.
This will help to increase the level of economic activity from its low level. Hence, the objective of taxation during depression should be to increase the purchasing power of the people. This can be realized by reducing the burden of taxation.
(c) Regulatory Effect:
Taxation can be used as an instrument to regulate consumption and projection. The composition and structure of production can be regulated and planned by using the instrument of taxation.
If the government wants to curb the production of a particular commodity, heavy taxation is desirable. Likewise, to stimulate production of certain commodities, tax exemptions and concessions can be given accordingly.
Consumption also can be regulated by using the instrument of taxation. Consumption of injurious articles can be restricted by imposing heavy taxation. Moreover, tax structure can be utilized to regulate import and export activities and thereby international trade.