Relationship between Debt and Taxes - Essay Example

?Insert Insert Grade Insert Insert Debt and Tax Governments always find themselves in awkward positions in thequest to balance their debts with the level of tax. Fiscal policy has mostly been directed at achieving the optimal level of revenue for government activities. However, there are cases where the revenue from taxation has not been enough and hence governments have resorted to borrowing. This paper has examined the relationship between tax and debt. There is a general observation that the level of tax may not necessarily determine the debt accumulation rates. The study recommends that there be further research on the best ways of finding a balance between the two. Debt and Tax Introduction With increased concerns on the fluctuation of the world’s economy, governments have been on focus on the way they have handled these shifts. Borrowing and taxation have been largely used by various governments through fiscal policy to offset the imbalances that have been created by constant economic downfalls. Most governments have historically relied on domestic taxes for the facilitation of various expenditures. However, with pressure that arises from budget deficits, it is usually common to hear of governments borrowing to make up for the deficits in their expenditure plans. In addition, for an individual borrower, it is usually a general principle that the amount loaned out is considered to be part of income and therefore subjected to taxation. Consequently, it has been generally concluded by many researchers that taxation is the best way to ensure that firms utilize debt in their capital structure. Such is the complex relationship between debt and tax that there are various dynamics towards the two concepts as illustrated in economics. In view of the mentioned relationship between tax and debt, this paper will explore the various issues that come up as a result of the close examination of the two concepts. The economic implications, justifications of fiscal measures with relation to the two and other arguments on the relationship between the two concepts will be discussed. This will be done through use of available literature on the two issues. As a result, the paper will finally make conclusions with regards to the relationship and implications of taxation and debt policies by governments. In addition, the paper will identify and recommend the areas on the two concepts that will need further research. To begin, it is important to understand the significance and meaning of the two terms with respect to the underlying discussions. Taxes are the main fiscal policy instruments largely employed by federal governments to ensure that there are balances on earnings in particular areas of the economy as well as have a resource pool for the financing of public expenditure for the benefit of the citizens. Taxation is therefore a tool used by treasury to ensure that citizens and firms operating in the economy contribute to a larger pool where the government can draw funds for its smooth functioning as well as provide basic amenities and services like healthcare, education and security to all citizens (Simpson 4). There are various categories of taxes with respect to various economies. The United States’ economy, for instance, has three basic categories of taxation. Simpson (6) enlists them as progressive tax, regressive tax and proportional tax. On the other hand, debt is as a result of borrowing by the government, firms or an individual. Usually, the most debts attract interests which are paid on top of the money borrowed for a specified period of time. As a result, taxation is connected with debt because the interest payable is classified as income and is therefore subjected to taxation. Taxation is used by government for fiscal policy measures that may be aimed at regulating the economy. For instance, in cases where there is a slow economic growth, governments may reduce taxation to some sectors to encourage borrowing and expenditure which therefore translates to growth. Governments use taxation to derive its source of income. However, sometimes taxation may not be enough and therefore federal governments may resort to borrowing which can be in future repaid using taxation related measures. As a result, there are various issues that may arise in the case of government decisions to borrow and further repay through levying of taxes and or tariffs. One of the critical issues has been on whether taxation is a good method of repaying debt. Most governments have always resorted to raising taxes and reducing expenditure as a means of paying off their debts. However, as Lewis (2) contends, this might not be the most effective way of helping governments do away with the debt burdens they may have after years of exploded expenditure. The main argument here is that taxation is likely to restrict growth rather than encourage one. In that case, the companies and other growth sectors are likely to reduce their spending due to increased taxes and therefore have an effect on the GDP. Eventually, the government will therefore find itself in the challenge of getting that extra amount to pay off its debts. On the other hand, it has been indicated by Lewis (4) that historically, countries like Britain and even the United States have been able to reduce their debts without having to increase the tax burden on tax payers. The main argument in this case is that countries should find a balance between slightly lowering tax on the growth areas of the economy and stabilizing the local currency. As a result, the government is able to provide some incentives to the production sectors which further acts as stimulus for growth. It is through this growth that the tax bracket of the government is able to expand to allow it pay its debts. Generally, it is therefore important for governments to ensure that growth in the economy is encouraged whereas ensuring that there is efficiency in collection of taxes. Another issue has been that of the relationship between taxation and government expenditure that may eventually determine the level of debt for the federal governments. Romer, Romer, Davis and Miron (140) has critically examined this relationship and come up with various observations that are significant for the paper’s discussions. Through ‘a starve the beast’ approach, classical economists as well as politicians have often thought that by reducing government revenue by tax cuts there are likely to restrict spending. However, there is no relationship between governments spending as illustrated by the writers in their study. It is therefore evident that the main objective of taxation is to ensure that economic growth is regulated and not federal expenditure. Consequently, it is therefore evident that debt may result from expenditure of government that may not be related to the level of taxation at any given time. However, it is clear that both tax and debt levels may depend and even affect the level of economic growth. However, tax cuts cannot be ruled out since it has an effect on the way government is likely to spend. For example, a higher tax regime is likely to affect interest or inflationary rates. As such, even if federal governments resort to ignoring the restrictions imposed through taxation and go ahead to borrowing, it is likely that they may find it difficult to do so. This is because high taxes discourages lending or leads to increased interest rates that may discourage borrowing on the part of the government. There is also another issue that might be raised as a result of government borrowing. As discussed earlier, it is clear that governments can only pay off their debts through revenue that is derived from taxation. From the issue of depending on taxes for offsetting federal debt rises another issue of future burden on tax payers arises. For example, when government borrowing increases as a result of increased expenditure, it is likely that future generations are likely to feel the effects of this excessive expenditure because governments tend to budget with future income. Conclusion It is therefore true to conclude that the relationship between tax and debt is a complex one. Whereas debt is independent of the level of taxes because governments have their own independent ways of determining expenditure, federal governments rely much on taxation to ensure that debts are settled. However, economic growth is reliant on the two concepts as discussed in this paper. It is therefore important that governments find a balance between expenditure and revenue collection so that the tax payers are not burdened presently or in the future. This is because increased taxes may affect tax payers presently whereas borrowing may need to be paid in future through revenue derived from tax. As a result, there is need for future research on the best techniques to be applied by federal governments to ensure that they find a striking balance between taxation and borrowing to fund its programs. In this way, economic growth may be cushioned from practices that have traditionally been resorted to by politicians. Works Cited Lewis, Nathan. “Raise Taxes And Cut Government Spending To Reduce Debt? Not Really.” Forbes, 2012. Web. 28 April, 2013 Romer, Christina; Romer, David; Davis, Stephen and Miron, Jeffrey. Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending/Comments and Discussion. Brookings Papers on Economic Activity, 1, (1), (2009), p.139-214. Simpson, Stephen. “Macroeconomics: Government - Expenditures, Taxes and Debt.” Investopedia, 2013. Web. 28 April, 2013. Read More