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

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

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

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.