Tax and Stabilisation of the Economy

One of the government’s roles is to maintain aggregate demand in the economy which is consistent with stability in employment. When the economy is in recession, government should bolster it by taxing less; and, when the economy’s demand outpaces supply, government should cut the excess demand back by taxing more. This is called counter-cyclical tax policy. A progressive tax structure achieves this objective and is called an automatic stabiliser. The objective of this chapter is to examine the economic stabilisation capability of a tax structure. Relatedly, it examines the concepts of ‘buoyancy’ and ‘elasticity’ of tax structures that measure the revenue response to rises in income. It analyses the impact of progressivity of taxes in an inflationary environment when it is possible for nominal incomes to rise, though not real incomes. Nevertheless, higher nominal incomes would drag taxpayers to higher tax brackets. This phenomenon is termed ‘fiscal drag’. To alleviate it, some inflation adjustment in tax payments is called for. On the other hand, during inflationary times, any slowness or lags in revenue collection deplete the real value of revenue collected. Tax administrations should structure revenue flows to guard against it. These aspects are considered in this chapter.