Taxation

Taxation can be used to finance government expenditure or to service the national debt. It can also be used to promote welfare or to change the distribution of income or wealth, and it can have the unintended effect of reducing welfare. Its use as an instrument of fiscal policy is considered in a separate article on that subject.

The effects of taxation

Every combination of the various forms of taxation has a different effect upon welfare, but all of them have certain common features. In the terminology of economic theory, each of them has an income effect and most of them tend to have substitution effects. A tax on biscuits reduces the income of biscuit buyers, but it would also induce some of them to switch their purchases to oa cheaper alternative such as bread. Summed over an economy as a whole, a given amount of taxation has an equal price effect and an indeterminate substitution effect. The price effect has no obvious effect upon taxpayers' welfare: it can be regarded as simply a payment for benefits received. The aggregate substitution effect, on the other hand, necessarily reduces welfare by distorting consumer choice. In other words, it induces consumers to forfeit some of the benefit that they would have received from buying the things that they would have preferred.