Research Paper: Significance of Tax Policies and Their Role in the Economy
Introduction
Most economies in the world suffer from the increased involvement of the government in crucial functions such as tax policies. Tax policies allow the collection and utilization of taxes, as an important activity that works towards providing revenue for the government to enable them to offer services to their citizens in an effective manner. However, when a government implements tax policies that act against the interests of the common citizen, the economy is bound to take a dip in the negative side (Stafford & Stapleton, 2017). Therefore, the issue of tax policies is very crucial as it plays a very significant role in the stabilization of economies of countries in the world (Mikesell, 2013). As such, this research paper seeks to investigate the significance attached to the role of tax policies in the stabilization of a given economy. Furthermore, the research paper will look into intricate aspects of tax policies and how their implementation may impact the eventual state of the economy. Consequently, the paper hopes to gain a deeper understanding on the level of significance of the role of tax policies in the achievement of the development goals and successful implementation of government policies through the realization of economic stabilization.
Economic instability is a contentious issue that had hurdled many countries in the past and the present. The great depression of 1930 has highly influenced both political and economic thinking. Countries like the US find the period to be the worst economic times they have experienced up to now. However, the economic recession of 2008 is another economic hurdle that impacted negatively on the United States economy. One thing or another causes all these issues of economic instability. The great depression period was as a result of many things which included bank failures, stock market crash, American Economic policy with Europe, drought conditions and the reduction in purchasing across the board.
The consequences of the great depression were very negative and drove governments to think of various ways to which they could attain stability in the future. Governments in the world came to a consensus to prevent such from ever happening again. Fast forward to the 21st century, the age of information, economic stability has improved significantly. The improvement is attributed to the different financial policies have been implemented by many governments in the world that have proven to be beneficial to the maintenance of the stability of different economies. However, some governments and regions still face significant economic troubles including the Brexit and the recent failure of Greece’s economy. Still, scholars suggest that the most appropriate way to achieve stabilization of the economy is through the implementation of more progressive tax policies.
However, countries like the US are so adamant on relying on progressive tax policies, especially those that touch on incomes taxes. It becomes an issue for developed economies to increase their revenues through income tax due to issues regarding the compliance of the citizens to such policies. The effects of such policies are very significant to attaining a balance in the negative effects of various industries in the economy. The government, therefore, uses taxes as a way to create a balance in the economy for the provision of services to the formal and informal sector of the economy. Therefore, the intervention by the government in most economies through tax policies enables the government to cover the cost of public goods and social costs of negative actions like industrial pollution that would otherwise not have been covered by the responsible firms.
Features of Tax Policies Focused on Economic Stabilization
The goal of economic stabilization has been the most significant one of most recommended tax policies in the United States. However, through time, stabilization has significantly faded as a priority goal of tax policies. Nonetheless, few distinct features characterize tax policies that focus on economic stabilizations. These features include:
- The reduction of reliance on tax expenditures as related to government spending. Tax expenditures allow government spending through a given tax code (Mikesell, 2013). The expenditures also give an implication of the tandem nature in which government subsidization moves about business cycles. This eventually causes a situation where the economy becomes destabilized. The issue of charitable contributions is used to illustrate this point further. The contributions tend to change with the fluctuation of the economic environment. This is basically due to the issue of the charitable contributions being tax deductible. Therefore, the replacement of the charitable deduction by government subsidies of non-profit organizations is used to reduce the procyclicality that exists.
- Income tax revenues are automatically sensitive to the business cycle conditions. This is evidenced by the collection of low revenue from incomes taxes in a period when the economy is experiencing a significant decline in its growth (European Bank, 2017). The degree to which such economies lower the government revenue is open to increase which in turn leads to the enhancement of the stabilization effect of the income tax. For instance, indexing of marginal income rates depends on the situation of the economy. Therefore, marginal income tax rates should be lower in times of negative economic growth than in times of positive economic growth.
- Tax expenditures have an increased sensitivity geared towards the business cycle. The indexing of these expenditures is done through analysis of the situation of the economy. Such that in times when the economy is experiencing a boom, the tax expenditures are low while in times of a bust the tax expenditure percentage increased significantly. Given this, it is paramount that some tax expenditure is eliminated as this will provide an opportunity to enhance the stability of the economy. However, some tax expenditures ought to be removed while some will remain in place. This action is motivated to control the degree to which tax expenditures adversely affect the business cycle.
Economic Stabilization and Income taxes
The world of economic professionals always debates on the macroeconomic effects of income taxes. From the Keynesian macroeconomic perspective, the fearless of tax policies as mentioned above leads to economic stability in various ways. The diagnosis of economic depressions and recessions by John Maynard Keynes remain as the foundation of modern macroeconomics, almost half a century after he died. Keynes believed that some aspects of income tax code have an avid effect on the stability of an economy. It is from this perspective that the suggestions of how tax policies create a more stable economy are made. The explanations of each suggestion are thereby grounded through the framework of Keynesian macroeconomics. The understanding of the Keynesian perspective drives us to understand how specific tax policies have a significant effect on the stability of the economy.
The Issue of Tax Expenditures
The definition of tax expenditures is quite elaborate. It defines the revenue losses that are attributed to deduction, exemption, or special exclusion from gross income thus providing special credit or a preferential rate of tax or a deferral of tax liability (Centre, 2016). Tax expenditures take away a significant portion of the revenue that is collected by the government that would otherwise be under a comprehensive income tax. In the economy, there are unique examples of tax expenditures which include charitable contributions, tax deductibility of mortgage interest and the employer-provided health-benefits from income exclusions. The cost of these expenditures has been rising significantly throughout the years. In 2008, the cost was approximated at 7% of the GDP (Dosi et al., 2015).
Given government expenditures, tax expenditures are viewed as their substitutes. The government reduces the money they spend by providing an exclusion from income. For example, the government has the responsibility to provide direct healthcare insurance to its citizens. The employer-provided health insurance is excluded from income and is thus not taxable making the government avoid spending on individual health insurance covers (Centre, 2016). Consequently, the government provides support to the provision of public goods through making charitable contributions to be tax deductible. This is done by the government trying to reduce their responsibility for production of public goods directly. All these are illustrations of how tax expenditures reduce government spending through loss of revenue that would otherwise be collected through comprehensive income tax.
Most tax expenditures have a negative effect on the stability of the economy as demonstrated in this paper. An economy that implements tax expenditures is less stable as compared an identical economy that government spending is implemented as opposed to tax expenditures. However, there is a way to tackle this negative effects of tax expenditures. Income-based phase-outs work towards offsetting the destabilizing effects of tax expenditures. This is achieved towards the reduction of income tax rates when the income reduces, and the degree of phase-out is subsequently reduced.
Policy Implications
The analysis presented in earlier paragraphs leads to recommendations for policies geared towards creating a more stable economy. For stabilization of the economy, government spending is preferred to tax expenditures. Direct spending programs, rather than tax expenditures should, therefore, be more supported as stabilization grows as a goal of tax policies. This is probably in particular situations where the item that benefits from tax expenditures moves in tandem with the economic situation of a country. The rate of the negative destabilizing effect of tax expenditures increases with the form of spending that benefits from tax subsidy become more receptive to the changes in output (Centre, 2016).
However, most tax expenditures have a direct relation to employment. For examples, individuals have to be in permanent employment to benefit from employer health cover exclusions. Employment-related tax expenditures tend to cost more than when tax expenditures are not related to employment. As such, economic development leads to increased employment which increased the destabilizing effect of tax expenditures. Therefore, it is imperative that the governments need to move to other forms of expenditure rather than tax expenditures to amend the situation and provide an environment of stable growth of the economy.
The Business Cycle and Average Income Tax Rates
The reduction of the reliance on tax expenditures about government spending is not the only way of stabilizing the economy. Another effective way of achieving the stabilizing effect is through reforms made in the income tax code. These reforms work towards achieving a reduction in the impact of the business cycle (European Bank, 2017). The issue of reforms is in tandem with the support of the implementation of the progressive income tax. Progressive income taxes provide a large stabilizing effect on the economy. Progressive income tax allows for the income tax rates to move in tandem with the business cycle such that negative shocks are met with a subsequent decrease in the tax rates and the income tax base. This will, in turn, lead to the larger decrease in tax receipts.
Income tax policy does more to ensure stabilization of the economy. Income tax achieves further stabilization through the fluctuation of marginal tax rates through different situations of the economy. For instance, when the economy is facing a bust, the marginal tax rates decrease significantly and increase when the economy expands. Policymakers can work towards implementing a business-cycle sensitive marginal tax rate structure through the automatic or discretionary mechanism to achieve more stabilization.
Fiscal Stabilization via Discretionary Mechanism
Throughout history, discretionary fiscal policies have been implemented to make the average tax rate more sensitive to the business cycle (Aghion, Hémous, & Kharroubi, 2014). In the periods of economic recession, Congress made changes to the income tax rates by reducing them to accommodate the difficult financial situation occurring due to the negative economic growth. The actions of implementing these policies can be very instrumental when conducted at the right time. This will create a situation where the average tax rates will be lower in times of a bust in the economy and increased in the boom of the economy. This will provide added stabilization to the economy by accomplishing a trend of changes in the average tax that corresponds to the business cycle.
However, the positive aspect of the discretionary fiscal policy depends on whether the legislative action taken towards altering the average tax rates is taken at the right time (McKay & Reis, 2013). If not, the legislative action thought to work positively will negatively affect the economy. This will, in turn, lead to the worsening of the economic situation. Therefore, the ability of discretionary fiscal policy to stabilize the economy is attainable only when the legislative process times the business cycle appropriately. However, because of the bureaucracy involved in the legislative process that makes it slow to enact the change in average tax rates, the discretionary fiscal policy happens to take place in an untimely manner when the economy has already decreased significantly, and it is starting to grow gradually.
This flaw in discretionary fiscal policy is what makes the discretionary monetary policy seem more appealing than discretionary fiscal policy in the stabilization of an economy (McKay & Reis, 2013). The implementation of such tax policies can therefore not be under the direct mandate of the Congress but could be delegated to an agency that performs all the taxing powers of the Congress in time with the business cycle changes. This would mean that the policy reforms would be subject to the Congress approval after review or recommendation by the agency. Upon such delegation of actions to an agency, the economic stability of the United States ought to improve with time to guarantee stability over a long period without late changes being made that negatively affect the economy. However, it would be considered unconstitutional for the Congress to delegate such powers to an agency. Although, the constitution allows for the delegation of such powers by Congress if an action is contingent on the occurrence of such events (McKay & Reis, 2013).
Automatic Fiscal Stabilization
Despite the fact that the delegation of tax powers by the Congress to a given individual agency is constitutional, it is not likely that such will occur. It is very probable that Congress will be reluctant to share its taxing powers with an individual agency that is one part of the Primary Powers that Congress holds. Therefore, it may prove to be impossible, although theoretically, to implement discretionary fiscal stabilization. However, enhance automatic fiscal stabilization has a high possibility. This can be achieved by policy makers allowing income marginal tax rates to be treated as a positive function of the overall growth rate of the economy (Aghion, Hémous, & Kharroubi, 2014).
Correspondingly, automatic fiscal stabilization can be attained in two ways. First, through adjusting tax expenditures (Aghion, Hémous, & Kharroubi, 2014). As noticed in previous sections of this research paper, tax expenditures tend to change in tandem with the business cycle. Given this, the subsidies geared towards tax expenditures can also be modified in response to the business cycle. This will work towards eliminating the destabilizing effect of tax expenditures. Secondly, through countercyclical tax subsidies which are attributed towards relating the subsidies rates to the changing business cycle (Aghion, Hémous, & Kharroubi, 2014).
Conclusion
Indeed, tax policies play a significant role in the stabilization of an economy given that tax rates have immense influence in the growth of the economy. Given this, the government should be very careful when dealing with matters concerning tax expenditures, government spending and marginal tax rates as they can have a detrimental or positive effect on the economy. Furthermore, policy changes that take place in through tax reforms ought to make possible the stabilization of the economy through ought the business cycle. The importance of tax policy and their changes have been shown throughout the paper. Furthermore, the constitutional framework that allows the change in the policy has proved to be influential in the attendance of stability in a country economy. Therefore, the role of the legislature and this tax policy has proved influential in the process of economic stabilization. Economic stabilization is therefore achieved through policy changes that are geared towards achieving average tax rates that are in tandem with the business cycle.
References
Aghion, P., Hémous, D., & Kharroubi, E. (March 01, 2014). Cyclical fiscal policy, credit constraints, and industry growth. Journal of Monetary Economics, 62, 41-58.
Centre, F. E. P. R. (April 29, 2016). Fiscal policy remains critical for much of the world economy. Vox Eu: Research-Based Policy Analysis and Commentary from Leading Economists, 2016-4.
Dosi, G., Fagiolo, G., Napoletano, M., Roventini, A., & Treibich, T. (March 01, 2015). Fiscal and monetary policies in complex evolving economies. Journal of Economic Dynamics and Control, 52, 166-189.
European Bank (2017). The role of fiscal and monetary policies in the stabilisation of the economic cycle. European Central Bank. Retrieved from https://www.ecb.europa.eu/press/key/date/2005/html/sp051114.en.html
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