Factors Affecting How Tax Revenue Changes When Tax Rates Change - Essay Example

Factors Affecting How Tax Revenue Changes When Tax Rates Change Introduction Although the government has various sources of revenue, taxation has always remained to be the main source of revenue and therefore effects of tax variation cannot be overlooked. Taxes are financial charges imposed by the government of a particular state or country on its citizens and businesses according to the law. On the other hand, tax revenue is the financial income earned by the government through taxation. The government can collect taxes directly or it can assign a third party to collect tax on its behalf. The government always adjusts tax rates imposed on its citizens to effect changes in the business sector, to alter economic development trend or to increase its income. This essay will therefore investigate whether raising tax rates implies an increase in tax revenue. The essay will also investigate factors that determine how tax revenue changes with variation of tax rates of a given country. Tax rates and tax revenues are two opposing and yet related factors; to determine how changes in one factor affect changes in the other factor requires a deeper analysis. Although tax rates are important to the government, tax revenues are of greater importance, in particular a government will need tax revenues more than high tax rates. The government will therefore be comfortable with increased tax revenues instead of high tax rates. Although the government raises tax rates to increase its earnings from tax revenues, high tax rates do not imply high tax rates. Then differences phases experienced in a business cycle are good indicators of the relationship between tax rates and tax revenues. In a booming economy, the government collects more revenue compared to an economy with high tax rates. A booming economy indicates prosperity and increase in wealth of a country and therefore the government should concentrate on economic growth to increases its tax revenues. In order to increase economic growth the government usually applies pro-growth policies that do not include raised tax rates. The US economy forms an appropriate case study for the analysis of effects of raising tax rates on tax revenues. The debt ceiling controversial debate conducted during the last financial year provides a good illustration of the controversy that exists between tax rates and tax revenues. In this debate, the democrats argued that the country would only realize the much needed tax revenue by increasing its tax rates. The debate focused on closing the budget gap that existed in the country with most people proposing that increased tax rates will increase revenue from tax required to close the budget gap. The debate also touched on the tax charged on high-income earners with most people proposing that the government does not earn enough tax from high-income earners. According to the proceedings of this debate, an increase in tax rates implies an increase in revenue collected from taxes. This relationship on tax rates and tax revenues only hold in the short term due to the sustainability of spending. An increase in tax rates for high-income earners will reduce their extreme spending behavior and costly social activities. A reduction in extreme spending reduces revenues that the government earns from value added taxes and other taxes charged on expenditures. This factor proves that increasing tax rates for the rich does not increase revenue earned from taxation. This also implies that increasing tax rates does not increase tax revenues earned by the government. The best proof for this argument was experience in 1993 when the US taxation authority decided to increase tax levied from high-income earners by increasing the tax rates based on the income earned. Although the government had anticipated high revenues, the results were a direct opposite since the revenue went down drastically only to be revived at the dotcom boom that followed the recession. These factors demonstrate that tax revenue depends more on a country’s prosperity as compared to a country’s taxation rate. The issues of taxation, tax rates, and government’s spending are dependent factors and they determine the economic growth of a country. From experiences, the government raises tax rates to cover for its expenditure arising from increased spending. Increasing government’s spending is a policy that aims towards economic growth. Although increased government spending is aimed at promoting economic growth a country’s economy does not always achieve economic growth from an increase in government spending. During rescissions, the government increases its spending as a policy to stimulate economic growth1. Increased government spending reduces revenue and creates enormous deficits in the budget. With reduced revenue, a country experiences a slow or reduced economic growth leading to a low GDP. A low GDP implies that a country experiences reduced economic activities or a country is spending more than its earnings. Most of the tax revenues are earned from value added tax and other taxes depends on people’s spending and therefore a reduction in economic activities implies a reduction in spending. Increases in tax rates increases government’s spending that slows economic growth of a country leading to a reduction in tax revenue. The federal government has personal taxes and tax charged on businesses as its main source of tax revenue. Although personal taxes earn the government more tax revenues than business tax, both sources of revenue are affected by variation of tax rates. Increase in tax rates increases the tax charged on products as VAT leading to an increase in the price of commodities. Price elasticity of demand indicates that an increase in the prices of commodities will result to a reduction in their demand. This is true for all goods and services that obey the law of demand and supply. Although price elasticity of demand is positive for Veblen and Giffen goods, most consumer products have negative price elasticity on demand. This phenomenon indicates that an increase in prices of basic commodities will result to a reduction in their demand. Increasing tax rates increases taxes levied on basic commodities such as VAT and this result to an increase in their prices. High commodity prices will therefore lead to a reduction in spending that will result into low tax revenues. Although variations on tax rates are mainly demonstrated as a micro economic factor, taxation also applies in macro-economic sectors of the economy. Unemployment is one of the main macroeconomic factors that have a close relationship with tax rates in a country. An increase in tax rates implies that people pay more for their earnings through the pay as you earn program. This however does not increase tax revenue since a country with high tax rates discourages workers. A country that has high PAYE tax resulting from increased tax rates experiences high level of unemployment or brain drain as people try to find measures to save their earnings. Such countries will also experience an increase in informal and illegal businesses as people try to evade taxes in order to maximize their earnings. Pay as you earn tax form the second main source of tax revenue earned by the federal government and therefore a reduction in the number of employees following the evasive measure will result into reduced tax revenues. This implies that raising tax rates affect the employment by reducing the number of available and willing workers, this result into a reduction of tax revenues earned from the sector. The business sector is also a major source of tax revenue earned by the federal government through taxes charged on business. The business sector has various taxes that contribute to a country’s tax revenue; these taxes include tax charged on licenses and other operational taxes charged on businesses. Increasing tax rates result in an increase in these taxes resulting in an increase in the cost of doing business. An economy that has high cost of doing business is unattractive and therefore people will tend to establish their businesses in countries or economies that have low cost in the operation and maintaining business. An increase in the cost of running business due to an increase in tax rates also implies that the businesses are making less profit. Such businesses are unsustainable and their owner will seek alternative source of income. Owners of unprofitable businesses will also tend to operate their business illegally in order to avoid taxation. This factor indicates that raising tax rates increases the amount of tax charged on business and this makes their businesses lose competitive abilities. Owners of unprofitable businesses will either close the business or shift their business to economies that provide favorable terms through low taxation2. This implies that an economy with high tax rates will have few businesses to impose taxes on and this will reduce the tax revenues earned by the government. Since historical time’s collection of taxes from people has always been a difficult affair, this is because most people are unwilling to pay tax. In most countries, people consider taxes imposed on them by the government to be unfair and inappropriate. Collection of taxes has always remained a struggle with the government trying to maximize its earnings from taxes while people always try to minimize or evade taxation. Increasing taxes is a method through which the government tries to maximize its earnings from taxation with the prospects of generating more revenue. When governments increase the tax rates anticipating increased tax revenues, people always respond by employing all possible measure to avoid or minimize taxation. Countries with high tax rates will be characterized by frauds and illegal dealings which not only denies the government the intended revenue but they will also cost the government extra revenue. This implies that increasing tax rates will encourage fraud and other illegal activities that people take to avoid or minimize taxation. This will result in a reduction in the tax revenue earned by the government and therefore an increase in tax rates does not increase tax revenues. Property taxes are taxes imposed by the government on owners of fixed properties such real estates. These taxes are charged recurrently, this implies that the property owners are required to remit their taxes on regular time intervals depending on the fiscal year of a country. Properties that are subject to this tax include land, improved land (land that has established infrastructures such as buildings) and movable properties such as motor vehicles. An increase in tax rates implies an increase in tax levied on properties and this affect the different types of taxes levied on property. An economy that has high property tax discourages investment and property ownership. A country that has low investments will have low economic growth and this implies reduced economic activities. Increasing tax rates increases tax charged on property owners discouraging property ownership, this leads to slow economic growth due to reduced economic activities leading to low tax revenues. Reduction in tax revenues from an increase in tax rates indicates that tax revenues respond positively to any changes in tax rates. Consumer behavior is the first factor that affects how tax revenues changes with respect to changes in interest rates. Increase in tax rate influence consumers to increase their rate of spending while a reduction in tax rate cause an increase in spending. Consumer behavior and responses from tax changes determine the rate that tax revenue changes in response to changes in tax rates. Government spending is the second factor that affects how tax revenue changes with respect to changes in tax rates. Government spending influence the amount of money in circulation, this influence prices of commodities that in turn affect the rate of change in tax revenue. Investment trend is the third factor that affects changes in tax revenue following changes in tax rates. Finally, the rate of unemployment in a country will affect or determine how tax revenue changes with changes in tax rates. Increase in tax rate will cause an increase in unemployment while a reduction in tax rates will cause a reduction in unemployment. The variation in the level of unemployment in a country will affect how tax revenue of the country changes by determining the taxable factors. Conclusions Taxation is the basic source of government revenue; the government may decide to increase tax rates in order to increase its income from tax. Increasing tax rates does not necessarily imply an increase in tax revenue as indicated in the following factors. Increasing tax rates causes an increase in government spending that result into a reduced GDP. A country or state that has low GDP has minimal economic activities and this reduces the tax revenue. Increasing tax rates causes a reduction in economic activities leading to slow economic growth, this results into a reduction in tax revenues. Increasing tax rates increases tax charged on consumer products and this restricts spending. Reduced spending implies that a country earns less revenue from taxation imposed on consumer products and this reduces tax revenue. This principle applies to property ownership whereby increased tax rates discourages investments and property ownership thereby reducing the taxable income. A country that has increased tax rates has a high cost of doing business and this discourages establishment of businesses. Such economies will experience low tax revenues due to reduced business activities or increased illegal and informal businesses. An increase in tax rates will also increase tax charged on workers and this will increase the unemployment index of such countries. High unemployment indicates low economic growth; this implies that the country has low GDP resulting to low tax revenue. It is not obvious to determine how changes in tax rate causes or influence changes in tax revenue, factors that affect how tax revenues changes with respect to tax rates are therefore important indicators of the relationship. Consumer behavior, investment trends, unemployment, and government spending are some of the factors that affect how tax revenues respond to changes in tax rates. These factors provide a clear relationship between the two variables by indicating how tax revenues respond to changes in tax rates. References Morgan, W, Katz, M L & Rosen, HS, Microeconomics, 2 nd European edition, McGraw Hill, 2009. Read More