Effects of Taxation on Consumption

Effects of taxation on consumption

A tax increases the price of the taxed good relative to the prices of untaxed or lower taxed goods. The increase in the relative price affects the taxpayer in two ways.

1. Income Effect of taxation

The tax reduces the purchasing power or real income of taxpayer. It takes resources away from the taxpayer and transfers them to the government. This is often referred to as the direct burden of the tax.

2. Substitution (or Price) Effect of taxation

The tax creates an incentive for the taxpayer to substitute less preferred but untaxed or lower-taxed goods for the more-preferred taxed good. The loss in consumer utility from this substitution is the excess burden (or welfare cost) of the tax.

Taxation influences the consumption as well. Such influence can be studied on the following grounds:

1. Taxation influence the Allocation of Resource of Individuals

Every individual has limited money income and allocate it to different uses. Taxation affects their allocation directly or indirectly.

For example, the income tax reduces the money income of a consumer and forces him to buy a smaller volume of goods and it reduces the standard of living of the consumers.

Likewise, a levy of indirect taxes on the goods of common consumption will affect the allocation of individual resources. Thus, taxes influence the allocation of resources of individuals.

2. Effects of Taxation on Consumption and Employment

Taxation reduces the purchasing power of the people and it reduces their consumption. The decline in consumption leads to decrease in effective demand for the goods and services, which in turn affects the production of these commodities. Ultimately, the reduction in consumption leads to a reduction in employment opportunities.

For example, due to rise in price, instead of getting two different commodities, the individual may buy more quantity of any one commodity to maximize the utility and his satisfaction.

3. Effects of Taxation on Consumption during Inflation and Depression

Taxation has different effects in times of inflation and depression. During the time of inflation, the purchasing power of the people is reduced by a raise in the rates of existing taxes or imposition of new taxes. This would control the consumption and therefore, help in bringing up stability in prices.

During the period of depression, taxation may be reduced. As the result of the reduction on direct tax rates, the people will have more disposable income and higher purchasing power and a decrease in indirect taxes leads to the reduction of selling prices. Both of them encourage the total consumption of the people and thereby the economic activities are induced in the country.

4. Regulatory Effect of Taxation on Consumption

Taxation may be used to regulate the production and consumption. Consumption can be regulated by taxing the production and use of certain commodities.

For example, the object of some taxes may be to reduce the consumption of certain harmful commodities such as liquors, cigars etc.

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