How do taxation influence productivity of a Nation?

Taxation can influence the production of a nation by influencing four basic factors. They are as follows:

  1. Ability to work, save and invest.
  2. Willingness to work, save and invest.
  3. Diversion or allocation of resources between industries and places.
  4. On the size of the industries.

Let us discuss these factors one by one.

How to taxation influence productivity of a Nation

How to taxation influence productivity of a Nation

Effects of Taxation on the Ability to Work, Save and Invest

Taxation transfers the money income from the public to the government and thereby reducing their purchasing power. The reduction in purchasing power reduces their ability to obtain necessaries and luxuries of life.

Thus, the levy of taxes on people reduces their consumption of necessaries and comforts, which lowers the standard of living. When the standard of living is affected, their efficiency and ability to work will also be adversely affected. This effect is strongly felt by the poor people. But the efficiency and ability to work of rich people is not so much affected by taxation.

The savings of the people depends upon their income. When income is reduced by taxation, savings will also be reduced. The ability of the people to invest largely depends upon their savings. When their savings are reduced by taxation, their ability to invest is also automatically reduced by taxation.

Effects of Taxation on willingness to Work, Save and Invest

Taxation affects the desire of the people to work, save and invest. If the willingness of the people to work, save and invest is affected by taxation, the production will automatically be affected. It is universally recognized that direct taxes have more adverse effect on the willingness of the people to work, save and invest.

It is argued on the grounds of psychological reactions of the people. That is, when the higher progressive taxation is levied, the Government takes the major portion of their additional earnings back. This may create a tendency in the minds of the people not to take risk to work hard to earn such a meagre income.

However, reasonable taxation may not have any such bad effect on the desire to work, save and invest.

Effects of Taxation on the Diversion of Economic Resources

While the volume of production of a country depends upon the ability and willingness to work, save and invest, the pattern of production depends upon the allocation of economic resources between different industries and regions.

Taxation can be used in the diversion of economic resources among the industries and regions. Thus, taxation can influence not only the size of production but also the pattern of production.

If the products of certain industries are taxed, their prices would rise and therefore, the demand for their product would reduce. And thereby, the profit is also reduced. This may result in the diversion of resources from these industries to some other industries whose products are subjected to no tax or low tax rate.

This diversion of resources may change the composition and pattern of output of industries. The extent to the diversion of resources takes place from taxed industries to non-taxed industries will depend upon the elasticity of demand and supply of products of such industries.

The diversion may be beneficial diversion or harmful diversion. Taxation on the commodities that are injurious to the health like cigarettes and liquors may discourage their consumption, which in turn affects their production. The factors of production engaged in these industries may be diverted to some other industries producing goods of common consumption etc. This is a “Beneficial Diversion“.

The taxation on the goods of common consumption will increase their price. Hence, the consumption of such goods may be reduced. This will affect the production of these commodities, and the resources used in their production may be diverted to the production of some other commodities which may be in the nature of luxury or harmful to health. Thus, such a diversion of resources is harmful and is socially not desirable. It is known as “Harmful Diversion“.

Effects of Taxation on the Size of Industries

When taxes are imposed without any discrimination on the commodities produced by both small and large-scale industries, the production of small-scale industries will be highly affected. This is because there cannot be any economies of large-scale operation. Thus, the cost of production of these industries will normally be high.

If taxes are levied on par with the large-scale industries, the total selling price of small sized industries will increase further. This will affect the competitive efficiency of small-scale industries, which in turn affects the production, and survival of these industries.

Hence, tax concessions should be given to encourage the production of these industries.

Share the Knowledge: