Effect of Taxation on the Economy - Essay Example

This also leads to a less desirable allocation of the society's resources, thereby bringing about an additional loss in the overall well being. This loss is often referred to as the excess burden of the tax. It is a measure of the inefficiency of the tax, which is to say that it takes more than 1 of private output resource and income to finance 1 of public expenditure. Estimates predict that the taxes would positively use resources only to a certain extent after which these resources will escape into informal sector and diminish tax growth and efficiency.

This paper examines the effects of different types of taxes as well as the tax rates on the economic efficiency of the country. It will first give an overview of the types of taxes that are levied and their relevance after which it will compare the tax revenues and the tax rates. It will be followed by a case study to amplify the effects of taxation on the economy. Taxes are direct and indirect in nature of collection. If the taxes are collected directly from the individuals and organisations on whom they are imposed then we refer to them as direct taxes while the taxes that are collected from person other than the one on whom it is imposed it is referred to as indirect tax.

Taxes can be divided into two major categories. . It is often argued that if the present system of levying income tax is replaced with the broad consumption based tax system it would greatly improve the economic efficiency on many accounts. It would eliminate the influence of taxes on the timing of consumption and it may also subject different sources of income to be included in the tax base and similar tax rates which would have otherwise not come under the tax net. A broader tax base would also help in lowering the overall marginal tax rates hence giving a wider choice to the consumer.

(James,2006) The lesser the tax system influences the economic choices of the firms and the consumers the more efficient it will be. Income tax by its nature affects two major house hold decisions. Firstly it reduces the price of current leisure in relation to its current consumption. This induces the households to cut back on their consumption and labor supply and increase the leisure. Secondly by taxing the capital income, the income tax brings down the price of current consumption in comparison to the future consumption thus discouraging house holds to save more thereby lowering the investment potential of the economy.

(Tuomala 1990) On the other hand the consumption based tax influences only the buying decision of the individuals and the returns to the capital income are left untaxed. To make a tax base broader and more neutral it is imperative to lower marginal tax rates. This way the comprehensive tax will improve the economic efficiency to a large extent. Tax Rates v/s Tax Revenues.Higher tax rates levied by the government equally affects all individuals in the society. The