🛍️ Higher prices
An indirect tax raises the price of a good. Consumers buy less of it, or pay more for the same amount. Poorer households may feel this most, because the tax takes a bigger share of their small income.
Fiscal Policy » The Impact of Taxation
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.2.3
- How taxes affect consumers and workers
- How taxes affect producers and firms, and the government's revenue
- How taxes affect total demand and inequality in the economy
- How to write a clear chain of cause and effect about a tax
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Unlock This CourseWho feels a tax?
A tax never stays in one place. When a government changes a tax, the effects spread out to five groups: consumers, workers, producers, the government and the whole economy. In this lesson we follow the effects one group at a time. Remember that the last lesson gave the reasons for taxes and how they are classified. Here we ask a different question: what happens when a tax is used?
Key terms:
- Tax revenue: the money the government collects from taxes.
- Disincentive: something that makes a person or firm less willing to do an activity.
The impact on consumers
Consumers are the people who buy goods and services. Taxes reach them in two main ways.
💵 Less disposable income
A direct tax such as income tax is taken from earnings. Households have less left to spend and save, so they may buy fewer goods and services.
Not every effect is bad. A tax on a demerit good may push consumers to choose healthier or less harmful goods. Tax revenue can also pay for public services that consumers use.
The impact on workers
Workers pay income tax on what they earn, so a tax rise cuts their take-home pay. The most important effect is on incentives to work.
- If a worker keeps a smaller share of each extra dollar earned, overtime or a promotion becomes less attractive. The tax is a disincentive to work more hours or to look for a better-paid job.
- Lower income tax does the opposite. Workers keep more of what they earn, so extra work becomes more rewarding.
- Some workers may respond differently. A worker with fixed bills might work more hours to make up for the lost pay.
So economists say a tax may reduce the incentive to work. The size of the effect depends on how high the tax is and on how each worker reacts.
Worked example: Falden
In Falden, a worker earns $400 a week and keeps $300 after tax. Her boss offers 5 extra hours of overtime, worth $100 before tax. If the government raises income tax so that she keeps only $60 of that $100, the reward for overtime is lower. She may turn the offer down. If the tax were cut so she kept $80, she is more likely to accept.
The impact on producers and firms
Producers are the firms that make goods and services. Taxes can change their costs, their sales and their plans for the future.
🏭 Costs
An indirect tax on a good or on a material raises the firm's costs. The firm may raise prices to cover it, or accept a smaller profit.
📊 Sales
If prices rise, consumers may buy less, so the firm sells fewer units. Higher taxes on workers' incomes can also cut the spending that firms rely on.
💡 Investment
Taxes on a firm's profits leave less money for new machines and buildings. High taxes may make a firm less willing to invest, and low taxes may encourage it.
How far a firm can pass a tax on to customers depends on how responsive demand is to price. This links back to the lesson on why price elasticity of demand matters for decisions. Where demand is inelastic, the firm can raise prices and lose few sales.
Taxes can also be used to give firms an incentive. A lower tax on firms that use clean energy, for example, rewards a change in behaviour.
The impact on the government
For the government, the main impact is revenue. Taxes pay for the spending you met in the lesson on the government budget, such as schools, health care and roads. More tax revenue can reduce a budget deficit or allow more spending.
But a tax does not always raise as much as expected. If a tax makes consumers buy much less of a good, or makes workers and firms reduce their activity, the amount of buying or earning that is taxed shrinks. Revenue may then be lower than planned. A government also has to decide how much to collect, because very high taxes can have harmful effects on the groups above.
The impact on the economy
Taxes affect the whole country in two key ways.
💲 Total demand
Total demand is all the spending in an economy. Higher taxes leave households and firms with less to spend, so total demand may fall. Lower taxes may raise it. This is why governments use tax changes to influence total demand.
⚖️ Inequality
Progressive taxes take a bigger share from high earners, so they narrow the gap between rich and poor. Regressive taxes take a bigger share from low earners, so they can widen it.
Notice that one tax can have good and bad effects at the same time. A higher income tax may reduce inequality and raise revenue, but it may also reduce incentives to work and total demand.
Common mistakes
Writing "tax is bad" or "tax is good" with no reason. Always say who is affected and how. Another slip is saying a tax raises prices for every good: only indirect taxes act on prices directly. A third slip is forgetting to say the effect may happen. Economists use "may" because the size of the effect depends on how people and firms respond.
Exam-style question
The country of Mervane plans to raise its income tax and also to put a new tax on imported fuel. The government says it wants to raise revenue and reduce the gap between rich and poor.
(a) Explain one way a rise in income tax may affect workers. [2 marks]
(b) Analyse how the new tax on fuel may affect producers. [4 marks]
(c) Discuss whether the higher taxes will be good for the economy of Mervane. [6 marks]
Model answer
(a) A rise in income tax cuts workers' take-home pay (1). This may reduce their incentive to work overtime or seek a better-paid job, because they keep less of each extra dollar earned (1).
(b) A tax on fuel raises the costs of producers who use it, such as transport firms (1). They may raise their prices to cover the higher costs (1). Consumers may then buy less, so sales fall (1). Profits may fall, leaving less money to invest in new equipment (1).
(c) For: the taxes raise revenue for the government to spend on public services (1), and a progressive income tax takes more from higher earners, which may reduce inequality (1). Against: workers have less disposable income, so total demand may fall (1), and higher taxes may reduce the incentive to work (1). Higher fuel costs may raise firms' costs and reduce their sales (1). Conclusion: overall the effect depends on how big the tax rises are and how workers and firms respond (1).
Exam tip
In a "Discuss" answer, give at least one effect for each side and then finish with a short conclusion. Name the group (workers, firms, government) every time you give an effect.