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I: The standard abbreviation for investment expenditures by the business sector, especially when used in the study of macroeconomics. This abbreviation is most often seen in the aggregate expenditure equation, AE = C + I + G + (X - M), where C, G, and (X - M) represent expenditures by the other three macroeconomic sectors, household, business, and foreign.

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TAX EFFECTS:

The primary reason that governments collect taxes from members of society is to finance government operations and provide public goods. However, taxes also create disincentives to engage in the taxed activity, which causes a change in the allocation of resources. This two consequences of taxes are summarized in two essential tax effects -- the revenue effect and the allocation effect. While all taxes have both, the key to effective government is minimize the allocation effect if the goal is to generate revenue and to minimize the revenue effect if the goal is to change the allocation of resources.
Governments collect taxes. They collect all sorts of taxes for all sorts of reasons. They collect taxes on eating, sleeping, driving, and working, that is, sales taxes (on food), motel taxes (on sleeping accommodations), fuel taxes (on gasoline), and payroll taxes (on employee wages). Finding an activity that is NOT subject to taxation is by no means easy.

One reason for the preponderance different taxes is that taxes are imposed for two basic reasons. The first is the revenue effect, the use of taxes to generate revenue needed by governments to finance government operations and provide public goods. The second is the allocation effect, the use of taxes to create disincentives and change the allocation of resources.

In a perfect world, governments could impose taxes that generate revenue, but have absolutely no allocation effect. Or governments could use taxes to alter the allocation of resources (presumably to improve efficiency), that have no revenue effect. In the real world, though, taxes have both effects. In our imperfect world, governments must balance the two effects. In some cases governments do an effective job of balancing the two and in other cases they don't.

Revenue Effect

The primary reason 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.

Allocation Effect

A second reason governments impose taxes is to change the allocation of resources. Because people would rather not pay taxes, taxes create disincentives to produce, consume, and exchange. If society deems that a particular good, such as alcohol, pollution, or cigarettes, is "bad," then a tax can reduce its production and consumption, and thus change the allocation of resources.

Conflicting Goals

While governments might impose taxes for one reason or the other, 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 soft drinks. A more specific soft drink sales tax motivates people to buy fewer soft drinks 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. Common examples are taxes on liquor and cigarettes.

<= TARIFFSTAX EFFICIENCY =>


Recommended Citation:

TAX EFFECTS, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2015. [Accessed: June 30, 2015].


Check Out These Related Terms...

     | taxation principles | taxation basics | revenue effect | allocation effect | 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 | allocation |


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 | elasticity |


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