Main effects of taxation on production are: 1. Effects on Ability to work, 2.Effect on the Ability to Save, 3. Effect on Ability to Invest
Taxes reduce disposable income. As such, the buying capacity and consumption expenditure are curtailed. These cause the standard of living to deteriorate. Consequently, efficiency and ability to work is adversely affected.
This happens in the case of low income group people. For the rich, however, the ability to work is not so much affected by taxation. To avoid the ill-effects of taxation, it is essential to grant exemption limits in income tax for the benefit of poor and middle income groups. In India, now an annual income up to Rs. 40,000 is exempted from income tax. Similarly, it is also necessary to avoid indirect taxes on essential commodities of mass consumption.
Again, there are some taxes which carry a beneficial impact on the ability to work. For instance, taxes on goods like liquor, cigarettes, opium, etc. which prohibit their consumption will lead to an improvement in general health and efficiency of those who are now addicted to them.
All taxes always have an adverse effect on one’s saving capacity.
Ability to save is adversely affected by taxation as taxes fall on income and saving is the function of disposable income. As disposable income declines, savings tend to decline.
Though normally, taxation is on the surplus income (the income which is in excess of the minimum standard of consumption level), the ability to save will be reduced proportionally to the amount of taxation, as it will adversely affect the marginal propensity to save by reducing the surplus income out of which saving is generated.
Hence, taxation would cause a reduction in the saving potentiality. Especially, the rich, having a high marginal propensity to save, are affected most due to progressive taxation based on the ability to pay criterion. A progressive taxation substantially reduces the ability to save of the rich class.
Ability to save is also reduced by indirect or commodity taxation, because these taxes cause a rise in prices which induces a higher spending from a given income, thus, resulting in less saving.
Similarly, the corporate savings (that of business firms), too, are reduced by corporate taxation. Corporate ability to save is, however, less affected than a wealthy individual’s ability to save since equity does not demand progression generally in the taxation of corporate income.
But, when government spends the tax income for the benefit of the poor, then their ability to save is enhanced. So, while evaluating the effects of a tax, the effects of public expenditure should also be taken into consideration to appraise the correct position in the economic system.
It is equally true that when direct taxes are imposed, they absorb the excessive purchasing power of the commodity, cause a deflationary effect which in turn enhances the real income of the common people and their capacity to save.
Ability to invest in the private sector evidently falls on account of the reduced saving ability caused by the tax imposition. Hence, all taxes have the immediate effect of reducing the amount of resources available for investment in the private sector.
In fact, taxation leads to a vicious circle in that when a tax is imposed, ability to save is reduced, less saving resources are available for investment in capital formation of the private sector, so there will be reduction in capital which in turn would lead to low productivity and low income, causing a further reduction in the ability of the people to save. As such, it may be stressed that to maintain and improve the investment function in a free economy, it is necessary to ensure that the rate of savings is not discouraged by taxation.
This gloomy picture of effect of taxation is, however, painted without taking into account the beneficial effects of public expenditure. In fact, public spending compensates and tends to surmount the adverse effects of taxation. The reduction in ability to work and save caused by taxation is more than mitigated by the amenities of life provided by State expenditure.
When the overall social benefits of expenditure exceed the social sacrifice involved in taxation, the net benefits of public spending will produce a favourable effect on the ability to save and work. Similarly, the reduction in private investment caused by taxation is more than offset by the public investment programmes.
In fact, the public sector investment may fill the investment gap of effective demand of the community and with due capital formation, can accelerate the tempo of economic development. Public investment may be designed to break the vicious circle of poverty in an underdeveloped economy. Thus, though analytically, the effects of taxation are discussed separately from those of public expenditure, in practice economic consequences of a fiscal policy can hardly be segregated.