Encyclonomic WEB*pedia: ALLOCATION EFFECT

ALLOCATION EFFECT:
A change in the allocation of resources caused by placing taxes on economic activity. By creating disincentives to produce, consume, or exchange, taxes generally alter resource allocations. The allocation effect is typically used when governments seek to discourage the production, consumption, or exchange of particular goods or activities that are deemed undesirable (such as tobacco use or pollution). This is one of two effects of taxation. The other (primary) is the revenue effect, which is the generation of revenue used to finance government operations.
Governments primarily impose taxes as a means of collecting the revenue needed to pay for the production of public goods and to generally finance operations This is termed the revenue effect. Taxes, however, also typically alter the allocation of resources. They change how resources are used in production, what goods are produced and who receives the production. This is termed the allocation effect.
Because people would rather not pay taxes and thus take steps to avoid doing so, 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/or consumption, and thus change the allocation of resources. Less of the undesired production is generated as resources are switched to other activity.
The allocation effect is most effective when a tax is limited and specific, placed on a good with a number of close substitutes, rather than a broader, comprehensive range of activities. For example, a tax only on root beer has a greater allocation effect than a tax on all soft drinks. A tax on soft drinks then has a greater allocation effect than a tax on all beverages. A tax on beverages then has a greater allocation effect than a tax on all food products. A tax on food products has a greater allocation effect than a tax on all consumption goods. And on it goes.
Disrupting the Market
The allocation effect occurs because a tax drives a wedge between the price buyers are willing to pay for a good (demand price) and the price that sellers are willing to accept (supply price). This tax wedge disrupts a market and consequently reallocates resources. Buyers are less willing to purchase and sellers are less willing to produce the taxed good. Resources are reallocated toward the consumption and production of goods with lower or no taxes.
Suppose, for example, that the Shady Valley city government decides to impose a $1 "sidewalk" tax on every pair of shoes sold within the city limits. While this tax is presumably collected to improve and maintain city sidewalks (the revenue effect), it's also bound to have an allocation effect.
First, as the tax wedge increases the price that buyers pay, they are less likely to purchase shoes (at least not those sold in Shady Valley). This will decrease the production and exchange of Shady Valley shoes. It could mean that some Shady Valley citizens will go shoeless (or at least purchase their shoes from outside the city limits).

Second, as the tax wedge decreases the price that sellers receive, they are less likely to provide shoes. This too will decrease the production and exchange of Shady Valley shoes. From a practical matter, it might even mean that one or more Shady Valley's shoe stores will go out of business.

Third, with the decrease in production and consumption of shoes in Shady Valley, resources are bound to be reallocated to another good. Shady Valley consumers might opt to spend their incomes on soft drinks, satellite television, or sensational jewelry rather than shoes, boosting the sales of these other goods. Or, more than likely, they will seek out shoes sold in a nearby city without a shoe tax, such as Oak Town.

Fourth, the buildings, owners, and employees of the former shoe shoes will probably redirect their productive activities to another area, such as the sales of soft drinks, the distribution of satellite television systems, or the production of sensational jewelry.
Generating Revenue
If the original goal of the Shady Valley shoe tax is to generate revenue, then the allocation effect could be quite troubling. The revenue effect is the primary justification for imposing most taxes. Governments, after all, require revenue to provide essential public goods and to otherwise finance government operations.
However, if the allocation effect is too effective, if the tax provides too much of a disincentive to produce, consume, and exchange shoes in Shady Valley, then the city government will not be generating revenue. Buyers will be discouraged from buying and sellers will be discouraged from selling shoes in Shady Valley. If so, then there will be no shoes to tax and no revenue generated.
Enter Elasticity
The allocation effect is works best when a tax is placed on relatively elastic goods (both price elasticity of demand and price elasticity of supply). Relatively elastic goods are, from the demand side, those with a large number of relative close substitutes, and from the supply side those in which productive resources can be easily switched from another production process.
Relatively elastic means that from both sides of the market, quantity is relatively sensitive to price changes. Small changes in price lead to large changes in quantity. As the tax increases the demand price and decreases the supply price, the quantities demanded and supplied experience relatively large changes. These large quantity changes then entail a corresponding reallocation of resources.
Alternatively for relatively inelastic goods, quantity is relatively less sensitive to price changes. Large changes in price are needed for relatively small changes in quantity. Changes in demand and supply prices then lead to relatively small changes in quantities and thus a correspondingly small reallocation of resources.
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.
Check Out These Related Terms...
     | tax effects | revenue 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 | allocation | three questions of allocation | resource 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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     ALLOCATION EFFECT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2025. [Accessed: December 16, 2025].