Effects of Taxes

Effect of Taxes on Supply and Demand

Below is a graphical representation of a market under heavy taxation; this limits the supply and demand for the goods. The reduction of profit discourages producers from supplying more goods, and producers pass on some of the tax to consumers, decreasing demand.

• CS=Consumer Surplus: a customer's excess value by buying at the equilibrium price.
• PS=Producer Surplus: the excess value producers get for selling up to the equilibrium price.
• DWL=Dead Weight Loss: the lost efficiency from disruptions in the free market.

In the graph below in figure 1, we see a market previously at equilibrium that had a tax implemented on it. Without a tax, all highlighted areas belong to either a consumer or producer surplus. We can see that the tax severely limits consumer and producer surplus.

Fig 2. - Tax Revenue Illustrated Model

Very important to note that not all lost surplus is collected as tax; deadweight loss occurs due to a decrease from the equilibrium quantity. This creates an inefficiency in the market, as both suppliers and consumers would be better off at equilibrium.

To better understand this graph, let's put a relatable example to what it demonstrates.

Consider the market for Cherry Pull 'n' Peel Twizzlers:

Try your best to imagine an evil government that hates happiness, and wants no one to enjoy Twizzlers, so they put a $4 tax on every package of cherry-pull 'n' peel Twizzlers.

In the example above, corresponding with figure 1, we can see a tax's impact on a market. Consumer and producer surplus are severely reduced at the tax revenue cost. Additionally, because the tax lowers the equilibrium quantity, there is a deadweight loss that could be occupied where the market is allowed to reach equilibrium. The problem with taxation on the market isn't the lost value to the tax but the overall loss of efficiency shown through deadweight loss.

Effects of Taxes on Savings

There are two types of savings in an economy, private savings and national savings. Private savings refer to individual savings, whereas national savings refer to the government's budget and how much it has to save at the end of a fiscal year.

In its most basic form, saving refers to the part of the income that is not consumed. As tax directly impacts the income one receives, it will also impact how much one is capable of saving.

Private savings

Let's consider the effects of taxes on private savings. Let's first consider what happens when there is a tax cut. You receive a specific salary every month, and part of your salary goes to the government through taxes, the other amount that's left, you either consume or save it.

Now, most people have a specific ratio of consumption and saving; some of them may consume 80% of their income and save 20%, whereas others may consume 40% and save 60%; that entirely depends on which circumstances one is in. In either case, when there is a tax reduction, the individual has more income. So whether they save 20% or 60%, the amount of personal savings will increase.

On the other hand, an increase in taxes would shrink the income one receives as they'd have to pay more taxes, thus receiving less income. As such, the amount of their savings would decrease.

National saving

Taxes provide the main source of government revenue, which it uses to spend on different projects in the economy. Government spending is intrinsically linked to tax revenue and is one of the main components of the aggregate demand curve. As such, taxes have an important implication for national savings and the overall economy.

When the government decides to reduce taxes, there is less national saving in the economy as the government's revenue decreases. This could mean that the government would have to spend less as it's receiving less revenue or keep the same rate of government spending but finance it with increased taxes in the future. As such, a reduction in taxes will lower national savings in the short run.

On the other hand, increasing taxes means that the government has more money to spend, which causes national savings to increase.

Effects of Taxes on Production

To consider the effects of taxes on production, we'd have to consider both parties involved in the transaction, the buyer and the seller. The tax effect level caused by the tax is not contingent on whether the state receives the income from the producer or the consumer; instead, it relies on the price elasticity of both supply and demand.

Inelastic supply and elastic demand

Because there is some elasticity in demand, the customer is particularly price-sensitive. A relatively little rise in cost will considerably reduce the number of goods or services required. The introduction of the tax leads to an increase in the price on the market and a reduction in the desired quantity, which hurts producers and consumers.

Because of the inelastic nature of the supply in this scenario, the business will continue to produce the same amount regardless of the price.

Because of the inelasticity of manufacturing, there is a substantial degree of variations to be made in sales. Because the producer cannot transfer the tax onto the customer, the financial burden of the tax is instead borne by the producer. However, due to the additional input cost, marginal revenue is lowered, so production drops in response to the tax introduction.

Supply that is elastic, but demand that is inelastic

In some cases, consumption is inelastic, which means that the customer will consume a certain quantity of goods and services regardless of the price. The manufacturer will be able to keep producing the same amount of the item, but they will be able to raise the price by the amount of the tax. As a direct consequence of this, the buyer will be responsible for paying the total amount of the tax. The production in this scenario will not change. However, consumers will experience a decrease in purchasing power.

Effects of Taxes on Labor Supply

To understand the effect of taxes on the labor supply, we must consider how labor supply changes in response to a change in income. A tax directly impacts the income one receives, affecting the labor supply.

In the near term, tax policy impacts the availability of workers. It's possible that lowering payroll taxes will encourage more people to enter the workforce or encourage those currently employed to work longer hours. Changes in the supply have little impact on production when the economy is performing much below its potential level. Even if they desire more jobs, they will have difficulty obtaining them if the circumstances remain as they are. On the other hand, if the economy is performing at or near its capacity, the labor supply may increase production.