Economics: Taxes and subsidies

Abstract

There are two types of tax systems that work simultaneously in an economy. These two systems are called direct and indirect taxation. Both of these systems have different effects on the economy in terms of an incentive or disincentive. Direct taxation is levied on the income of people. They pay directly in taxes out of the income they earn. Similarly, indirect taxation is not levied on people's income. Instead, it is levied on the spending of people. They pay the taxes each time they make a purchase.

Direct taxes cannot be avoided. Anything that is earned will have to be given to the national exchequer. Indirect taxation can be avoided by reducing the spending. Indirect taxation leads to substitution effects. Since people know that their effort will earn less than the actual amount they were getting before the tax is levied, they will think that leisure has become cheaper for them now. For example, if a consumer was earning $10 and no tax was being levied on his salary, then any leisure hour was costing him $10. Now after a 10% tax is levied on his salary, each leisure hour is costing him only $9. Hence, leisure has become cheaper for him. This will lead to the substitution effect as people would substitute labor for leisure. Direct taxation can be a disincentive to work and would leads to more people choosing leisure over labor. Similarly, when the tax is reduced, leisure hour becomes expensive and more people try to substitute leisure for work. Hence, tax reduction helps in motivating people to expend more effort to their work. (Brue & McConnell 2006)