Taxation

Taxation As A Tool Of Fiscal Policy Taxation plays a major role in managing the fiscal policy of a state. Tax can be defined as a person’s share, contribution and obligation of the cost for the maintenance of socio-economic order and governance, and to enjoy the sovereign rights, privileges and powers of a state. In other words, tax is a sum of money paid by a person in whatever form to the state which is backed by law. There are two types of tax; these are direct tax and indirect tax. Direct taxes include income tax, corporate tax, tolls and rates. Also, indirect taxes include Value Added Tax (VAT), excise duties, and import and export duties. Fiscal policy is the use of taxes and government spending to control the economic activity of a country. It is classified into two; expansionary fiscal policy and contractionary fiscal policy. These have to do with increasing and reducing taxation, subsidies and government expenditure or spending, respectively. The various economic conditions that could affect the economic stability of a state include; aggregate demand, balance of payment, unemployment, inflation, deflation, etc. The most immediate effect of fiscal policy is to change aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of the two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Secondary, if the government cuts taxes or increases transfer payment, households’ disposable incomes rises and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand. Moreover, fiscal policy may be employed to manage aggregate demand so as to control the price level. If there is a need to increase aggregate demand we may reduce taxation, increase subsidies or increase government expenditure. When direct taxes are reduced workers disposable income rise and this may lead to increase in effective demand. What is more, tax as fiscal policy helps to control the balance of payment of a state. Balance of payment talks about the relationship between export and import. When export exceeds import there is balance of payment surplus which is a strong indication of economic growth and if import exceeds export there is balance of payment deficit, indicating a down-turn of the economy. Taxation functions to protect local industries from foreign competition through the use of import duties, turnover taxes/VAT and excise duties. This has the effect of transferring a certain amount of demand from imported goods to domestically produced goods which has effect on their profit and cost of production. Government as a measure to protect the local industries by discouraging the importation of certain goods such as textiles into the country may increase import duties on such goods which compete seriously with the locally produced ones, which even goes a long way of causing the collapse of those firms. When such tax policy is achieved the likelihood of employees in such industries becoming unemployed is eliminated thus ensuring economic stability. Also unemployment is one of the conditions that could affect the economic stability of a state. Taxation as a fiscal policy may have effect on unemployment. For instance, the reduction of direct tax makes more income available which will increase aggregate demand. The increase in aggregate demand has the effect of increasing prices and profits which could entice firms to produce more by employing more factors of production such as labour. On the other hand a reduction of indirect taxes reduce cost of production and increase profit which would be ploughed back to expand the firms and thereby creating more job opportunities. Furthermore, fiscal policy is very useful weapon for controlling the rate of inflation. During inflationary period there is more money chasing fewer goods in an economy. When the expenditure on non productive projects is reduced or the rate of taxes is increased then the purchasing power of the people reduces and government spending as a fiscal policy may be decreased to reduce disposable incomes. Inflation hurts the poor by lowering growth and by redistributing real incomes and wealth to the detriment of those in society least able to defend their economic interests. High inflation can also introduce high volatility in relative prices and make investment a risky decision. Prudent tax policies can result in low and stable inflation. Economic growth is the basis of increased prosperity. Growth comes from the accumulation of capital (both human and physical) and from innovations which lead to technical progress. Accumulation and innovation raise the productivity of inputs into production and increase the potential level of output. The rate of growth can be affected by policy through the effect that taxation has upon economic decisions. A decrease in taxes increases the returns to investment (in both physical and human capital) and Research and Development (R&D). Higher returns mean more accumulation and innovation and hence a higher rate of growth. Some public expenditure can enhance productivity, such as the provision of infrastructure, public education, and health care. Taxation provides the means to finance these expenditures and indirectly can contribute to an increase in the growth rate.