Taxes: Bad for the Economy, Good for the Soul?June 21st, 2019 by Tanner Wrisley
Just about every human on earth is affected by taxes in some way. In the U.S., taxes have long been at the core of political disagreement and are very much a point of contention today. But what are their true implications on markets and the economy? One thing to keep in mind, taxes impact society in more ways than just the pure economic consequences. Many, if not most, taxes are levied to produce a positive net benefit to our country in spite of potential economic inefficiencies. The bulk of this article will focus on the economic impact of a mandatory tax on citizens.
At a very simplistic level, taxes redirect money to the government who chooses where funds are allocated, instead of the individual consumer. When a person earns an income, a portion goes to taxes and the rest is considered disposable income. Disposable income is the portion the individual can use to spend on products and services he or she chooses. Taxes go to federal, state, and local governments and are distributed back out to this individual, only in the areas of spending that the government chooses. In theory, after the government spends the taxes on improving roads, paying unemployment benefits, subsidizing health care, etc. the country as a whole should get the same total dollar amount of benefit as if all the money were left in the hands of the consumers. However this is not true. Taxation creates an economic phenomenon called deadweight loss.
The best way to describe this is through an example. Say the government introduces a 20% tax on milk. Before the tax, grocery stores were selling milk at $3/gal and so now they must increase the price to $3.60/gal. Many individuals will still buy milk, but there will be some that get pushed out of the market for milk by this increase. The revenue lost because of these people deciding not to buy milk at a higher price contributes to the deadweight loss.
Additionally, money has a multiplying effect. So when funds are taken out of the economy (those consumers not buying milk), the deadweight loss is actually larger than the initial effect. The grocery store uses the revenue from their milk sales to pay employees, buy supplies, invest, and expand. Then their employees and suppliers use the grocery store’s money to spend on their employees and investments. This process continues on down the line and is essential to the growth and overall health of an economy. The money from the consumers that chose not to buy milk, is then not shared through this chain as it otherwise would have been, making the deadweight loss effect even greater.
Additionally, taxes decrease business’ margins. If taxes continue to increase, the lost revenue from individuals leaving the market may make it harder for some firms to pay their bills causing bankruptcy. Bankruptcies are a natural part of a free economy, however, this deadweight loss effect may push a few more firms off the edge that may have otherwise survived. These layoffs and losses of economic players also add to the long-term effects of levying taxes.
Conversely, taxes do have benefits on an economic basis as well. Pooling citizens’ money together can sometimes create economic efficiencies that would not have been achieved otherwise. Common examples of this are social security, the military, and even the government itself. Also, tariffs are used many times to protect domestic companies. The idea is that taxing foreign goods will increase the price of products abroad, which increases demand for products domestically (global benefit goes down, while domestic benefit goes up).
In many cases, taxes are issued knowing full well that there will be negative economic consequences, but that the social benefits will outweigh them. An example of this is putting a tax on tobacco products. In this case, the government is counting on the deadweight loss to hopefully push individuals out of the market for tobacco. The idea is that the social benefits of less tobacco users outweigh the economic loss in products sold.
Taxes or any government policies should be implemented based on the overall net benefit to society, of which, the economic result is just one part. The true amount that deadweight losses have on a real-life economy is hard to measure with so many moving parts. All of the examples used in this article assume these changes are made in a vacuum and everything else is equal. This is obviously not the case when considering the scale under which global economies work. Nonetheless, virtually all economists agree that in a free market, taxes create inefficiencies in markets and economies. The division we see between politicians, citizens, or any individual, occurs when deciding if the overall net benefits of a specific tax, outweighs the cost. At Anchor Bay, we don’t worry about things that are out of our control. But we do pay specific attention to taxes and their effects on economies and markets. These considerations lead to portfolio adjustments that help keep your accounts in line with their individualized goals.