March 23, 2018 

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GOVERNMENT PURCHASES LINE: A graphical depiction of the relation between government purchases and national income (or gross domestic product) that plays a role in Keynesian economics and the Keynesian cross. The slope of this line is positive, greater than zero, less than one, and goes by the name marginal propensity for government purchases. The vertical intercept of this line is autonomous government purchases. The aggregate expenditures line used in the Keynesian cross is obtained by adding this government purchases line, as well as, investment expenditures and net exports, to the consumption line. The government purchases line is also combined with investment expenditures for the Keynesian saving-investment model.

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The generation of revenue used to finance government operations that results from placing taxes on economic activity. The revenue effect is the primary reason that governments impose taxes on members of society. Without the revenue generated from taxes, governments could not provided valuable and essential public goods nor undertake other government operations. This is one of two effects of taxation. The other is the allocation effect, which is the change in resource allocation that results because taxes create disincentives to produce, consume, and exchange.
The principal reason that governments impose taxes is to generate the revenue used to finance the operation of government, most notably the provision of public goods. That is, taxes transfer purchasing power from members of society to governments. Taxes give governments command over society's resources. Governments need this command over resources to build highways, defend the nation, educate the population, and maintain the legal system.

Taxes, however, also create disincentives to produce, consume, and exchange. This is termed the allocation effect. Unfortunately the allocation effect is at odds with the revenue effect. Taxes designed to generate revenue don't work as well, if they also lead to a significant change in resource allocation. Alternatively, taxes designed to alter the allocation of resources don't work as well if they generate a significant amount of revenue.

The revenue effect is most effective, with the least allocation effect, when a tax is placed on a wide range of economic activity. For example, a tax on all consumption goods works better than a tax only on food products. A tax on all food products works better than a tax only on soft drinks. A tax on all soft drinks works better than a tax only on root beer. A tax on all root beers works better than a tax only on Tasty Ted's brand of root beer. When it comes to revenue, the broader the better.

Going for Income

Income is perhaps the best tax base for generating revenue with the least significant allocation effect. Income is one of the broadest economic activities around, and thus unlikely to generate a significant allocation effect. Of course, a tax on income can create a disincentive to earn income, with effort directed instead toward non-income earning activity such as leisure time or household production. But compared to other potential tax bases, income has relatively little allocation effect.

And while a number of different "income" taxes are used by governments, those that tax all income rather than only some income are also most effective in generating revenue with minimal allocation effect. For example, Social Security taxes only tax wage earnings (excluding interest, profit, rent, etc.). Corporate income taxes only tax corporate profits (excluding wages, interest, rent, noncorporate profits, etc.). Even those these alternative "income" taxes are designed to generate revenue, they also have relatively greater allocation effects than the standard personal income tax.

Enter Elasticity

The revenue effect is works best when a tax is placed on relatively inelastic goods (both price elasticity of demand and price elasticity of supply). Relatively inelastic goods are, from the demand side, those with very few close substitutes, and from the supply side those in which productive resources cannot be easily switched from another production process.

Relatively inelastic means that from both sides of the market, quantity is relatively insensitive to price changes. Large changes in price are need to create small changes in quantity. As the tax increases the demand price and decreases the supply price, the quantities demanded and supplied experience relatively small changes. These small quantity changes translate into the generation of revenue.

Alternatively for relatively elastic goods, quantity is relatively sensitive to price changes. Small changes in price are result in relatively large changes in quantity. Changes in demand and supply prices then lead to relatively large changes in quantities and very little revenue is generated.

Conflicting Effects

While governments might impose taxes either to generate revenue or to change the allocation of resources, all taxes have both effects. A tax intended to generate revenue changes the allocation of resources. A tax intended to change the allocation of resources generates revenue. However, different taxes achieve the two effects to different degrees. Ideally, governments want revenue generated by taxes with little allocation effect. And when governments impose taxes to discourage a particular activity, success entails little revenue effect.

The key to generating revenue is to identify taxes that have very little allocation effect. This is best achieved with broad-based taxes that create the same degree of disincentives for all types of goods and activities. For example, imposing a sales tax on ALL goods and services is better than one on ONLY root beer. A more specific root beer sales tax motivates people to buy less root beer and more of other goods, which then reduces the generation of revenue. A broader sales tax on ALL goods entails fewer options for switching to other goods. If everything is taxed, it matters not what your buy, you still have to pay the tax.

On the other side of the incentive picture, some taxes originally created to change the allocation of resources are too good at generating revenue. Governments might come to rely on this revenue and even act to "encourage" the revenue-generating activity. Common examples include "speeding traps" or "parking tickets" that might be used by local governments more to finance their operations than to discourage traffic violations. And in some circumstances, governments justify a tax with the allocation effect, knowing that very little disincentive is created, and the primary consequence is to generate revenue.


Recommended Citation:

REVENUE EFFECT, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2018. [Accessed: March 23, 2018].

Check Out These Related Terms...

     | tax effects | allocation effect | taxation principles | taxation basics | tax equity | ability-to-pay principle | benefit principle | horizontal equity | vertical equity | tax proportionality | proportional tax | progressive tax | regressive tax | tax efficiency | tax incidence | tax wedge | deadweight loss |

Or For A Little Background...

     | taxes | government functions | efficiency | equity | public finance | public goods | allocation | elasticity | price elasticity of demand | price elasticity of supply | demand price | supply price |

And For Further Study...

     | public choice | good types | market failures | public goods: demand | public goods: efficiency | tax multiplier | personal tax and nontax payments | transfer payments |

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