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EQUILIBRIUM, SHORT-RUN AGGREGATE MARKET: The state of equilibrium that exists in the short-run aggregate market when real aggregate expenditures are equal to full employment real production with no imbalances to induce changes in the price level or real production. In other words, the opposing forces of aggregate demand (the buyers) and short-run aggregate supply (the sellers) exactly offset each other. Equilibrium in the short-run aggregate market achieves balance in the product markets and financial markets, but not in the resource markets. It also involves simultaneous equilibrium in the aggregated financial and resource markets.

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TAXES:

Legally mandated payments to government that are NOT made in exchange for a good or service. The primary reason government collects taxes is the revenue needed to pay for government expenditures, especially administrative expenses and the provision of public goods. Taxes are one of two methods of obtaining the revenue the government sector uses to pay for expenditures. The other is government borrowing.
Taxes are the primary means used by the government sector to obtain the revenue needed to operate. Taxes give government control over resources and allocation decisions that can then be used to carry out specific functions and activities such as defending the nation, constructing streets and highways, or providing education. Without taxes, there is no government. With government, taxes are inevitable.

A Taxing Array

Given the length of time that governments have existed (since the dawn of civilization), it is no surprise that a wide variety of taxes exist. All sorts of goods, services, commodities, exchanges, and activities are subject to taxation. Here is a short list of the more important taxes.
  • Income: Income taxes are those based on the amount of income earned or received by members of society. The most common income tax is the personal income tax that comes due April 15th of each year. In principle, this is a tax on all income received. In practice, a great deal of income is excluded. Other types taxes are applied to specific types of income or income-generating activities. Two important examples are the corporate profits tax, placed on income or profit received by corporations, and the Social Security tax, placed on the wage earnings of workers. Income taxes are the primary source of tax revenue at the federal level and is increasingly important for many state governments.

  • Sales: A popular activity subject to taxation is the sale or exchange of commodities. General sales taxes are those placed on the retail sales of almost all goods purchased within a state, county, or city political jurisdiction. In some cases, services or specific types of goods (such as food or medicine) are excluded. In other cases, the sales tax (often termed excise tax) is placed only on a specific commodity, such as gasoline, alcohol, or tobacco. Sales taxes are a major source of revenue for most state and local governments.

  • Wealth: A number of taxes are placed on different types of wealth. At the top of this list for most people are property taxes on homes and personal possessions. Another type of wealth taxes is the inheritance tax levied on assets passed along after death and the gift tax levied on assets passed only while still living. Property taxes are a key source of revenue used by local governments to finance education expenditures.

A Share of Income

Although taxes are placed on property or sales, all taxes are ultimately paid from income. Some taxes constitute a larger proportion of income for those with more income and others less. This observation gives rise to three types of taxes--proportional, progressive, and regressive.
  • Proportional: A proportional tax is one in which everyone pays the same percentage of income in taxes regardless of income level. A proportional income tax exists if everyone pays 10 percent of their income in taxes. Suppose, for example, that Pollyanna Pumpernickel pays $1,000 of tax on $10,000 of income (10 percent) and Winston Smythe Kennsington III pays $10 million of tax on $100 million of income (also 10 percent). This tax is proportional because both pay the same tax rate. While many taxes seek to be proportional, few achieve this in practice.

  • Progressive: A progressive tax is one in which those with more income pay a larger percentage of income in taxes. A progressive income tax exists if the tax rate increases with income. Suppose, for example, that Pollyanna Pumpernickel pays $500 of tax on $10,000 of income (5 percent) and Winston Smythe Kennsington III pays $20 million of tax on $100 million of income (20 percent). This tax is progressive because those with more income pay a higher tax rate.

  • Regressive: A regressive tax is one in which those with more income pay a smaller percentage of income in taxes. A regressive income tax exists if the tax rate decreases with income. Suppose, for example, that Pollyanna Pumpernickel pays $2,000 of tax on $10,000 of income (20 percent) and Winston Smythe Kennsington III pays $5 million of tax on $100 million of income (5 percent). This tax is regressive because those with more income pay a lower tax rate.

Why Tax?

The more astute leaders of the government sector have long recognized that taxes can accomplish two, usually conflicting, objectives. These two objectives are the revenue effect and the allocation effect.
  • Revenue Effect: First, and usually foremost, the government sector collects taxes to generate the revenue needed to undertake government functions, such as national defense, education, and the judicial system. Without revenue, the government sector could not operate. Most taxes--especially income, sales, and property--are primarily designed to achieve the revenue effect.

  • Allocation Effect: Second, and also important, the government sector often places taxes on specific goods or activities to change production, consumption, and exchange incentives. The allocation effect is the goal if taxes are placed on goods that society deems "undesirable," such as alcohol and tobacco.
Ideally, a tax that pursues the revenue effect has no allocation effect. If the goal is to generate revenue, then discouraging the activity taxed through the allocation effect is counterproductive. Alternatively, a tax that pursues the allocation effect should have little or no revenue effect. If the goal is to discourage an activity, then the less revenue generated, the better.

Taxing Principles

When government officials ponder taxes, they are usually most concerned with the revenue needed to keep the government sector operating, that is, the revenue effect. As such, they usually levy taxes on those who can afford to pay taxes, those who have the income. However, in some circumstances taxes are directed towards those benefiting from the provision of government services. This suggests two important principles of taxation:
  • Ability-to-Pay Principle: This principle states that taxes are based on the income or resource-ownership ability of members of society. In other words, those with more income pay more taxes. The best example of a tax designed according to the ability-to-pay principle (in theory at least) is the personal income tax.

  • Benefit Principle: This principle states that taxes are collected from those members of society who receive benefits from the goods provided by the tax revenue. This is often reflected with entrance or user fees for such government goods as golf courses, libraries, and national parks. College tuition and gasoline taxes are other examples that apply the benefit principle.
The ability-to-pay and benefit principles reflect the alternative functions performed by government. Some government functions, such as college education, involve the provision of services that can be effectively provided in exchange for a user fee. In these cases, the benefit principle is invoked. However, other government functions, such as national defense, cannot be exchanged for a user fee. In fact, these functions generally involve services that benefit all members of society without exception. In these cases, it makes sense to collect tax revenue from the general public using the ability-to-pay principle.

The Circular Flow

The role taxes play in the macroeconomy can be illustrated with the circular flow model. The circular flow captures the continuous movement of production, consumption, income, and factor payments between producers and consumers.

The Circular Flow
Circular Flow
A basic representation of the circular flow is displayed to the right. The components of this model are the four macroeconomic sectors--household, business, government and foreign--and the three macroeconomic markets--product, resource, and financial.

The household sector at the far left contains the consuming population of the economy. The business sector at the far right includes all of the producers. The government sector is positioned in the middle of the diagram and the foreign sector is at the very top.

The product markets near the top of the flow direct production from the business sector to the household sector in exchange for payment flowing in the opposite direction. The resource markets at the bottom of the flow direct factor services from the household sector to the business sector in exchange for payment flowing in the opposite direction. The financial markets located just above the resource markets divert saving from the household sector to business and government borrowing.

The circular flow indicates that the income used by the household sector to purchase goods through the product markets is obtained by selling factor services through the resource markets. It also indicates that the revenue used by the business sector to pay for factor services obtained through the resource markets is generated by selling goods through the product markets.

Taxes are the flow between the household sector and the government sector. The government sector obtains income used for government purchases by mandating the diversion of taxes from the household sector. This diversion of taxes reduces the income available for consumption expenditures and saving.

A Touch of Policy

Taxes are commonly used as a policy tool by the government sector to pursue specific economic goals.

  • On the macroeconomic side of the economy, taxes can be used to promote the macroeconomic goals of full employment, stability, and economic growth.

    In particular, taxes are an important means of addressing the unemployment and inflation problems of business cycles with fiscal policy. If the economy has high rates of unemployment due to a business-cycle contraction, then a reduction in taxes can provide stimulation. If the economy is encumbered with high rates of inflation during a business-cycle expansion, then an increase in taxes might damped the economy enough to keep prices in check.

    Taxes can also be used to encourage investment in the quantity and quality of resources need for economic growth. Placing taxes on consumption, for example, can encourage people to divert income to savings, which can then be used for investment expenditures on capital goods.


  • On the microeconomic side of the economy, taxes can be used to promote the microeconomic goals of efficiency and equity.

    Because taxes affect the incentives to produce, consume, and exchange, they are often used to promote the efficiency of specific goods that otherwise would be subject to market failures and inefficiency. If the commodity exchange in a market includes an external cost that causes an inefficient allocation of resources, then a tax on the commodity can internalize the cost and correct the inefficiency.

    Additionally, taxes are used as a means of redistributing income and wealth to achieve what is deemed a more equitable income distribution. The revenue collected from a progressive income tax, for example, can be used to redistribute income from the wealthy to the poor.


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Recommended Citation:

TAXES, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2017. [Accessed: August 18, 2017].


Check Out These Related Terms...

     | government borrowing | government purchases | government expenditures | investment expenditures | investment | investment borrowing | consumption expenditures | consumption | saving | net exports |


Or For A Little Background...

     | government sector | government functions | public sector | macroeconomic goals | microeconomic goals |


And For Further Study...

     | circular flow | business cycles | economic goals | macroeconomic sectors | macroeconomic markets | macroeconomic problems | macroeconomic theories | political views | ownership and control | stabilization policies | incentive |


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