The Economic Effect of Taxes

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The imposition of taxes results in the reduction of the disposable income of the taxpayers. This will reduce their expenditure on necessaries that are required to be consumed to improve efficiency. As efficiency suffers ability to work declines. This ultimately adversely affects savings and investment. However, this happens in the case of Taxation on rich persons has the least effect on the efficiency and ability to work. Not all taxes, however, adversely affect the ability to work. There are some harmful goods, such as cigarettes, whose consumption has to be reduced to increase the ability to work. That is why high taxes are often imposed on such harmful goods to curb their consumption.
But all taxes adversely affect the ability to save. Since rich people save more than the poor, a progressive tax rate reduces savings potential. This means a low level of investment. A lower rate of investment has a dampening effect on the economic growth of a country.
Thus, on the whole, taxes have a disincentive effect on the ability to work, save and invest.
Effects on the will to Work, Save and Invest:
The effects of taxation on the willingness to work, save and invest are partly the result of the monetary burden of tax and partly the result of the psychological burden of the tax. Taxes which are temporarily imposed to meet any emergency (e.g., Kargil Tax imposed for a year or so) or taxes imposed on windfall gain (e.g., lottery income) do not produce adverse effects on the desire to work, save and invest. But if taxes are expected to continue in future, it will reduce the willingness to work and save of the taxpayers.
Taxpayers have a feeling that every tax is a burden. The taxpayers' psychological state of mind has a disincentive effect on their willingness to work. They feel it is not worth taking extra responsibility or putting in more hours because so much of their extra income would be taken away by the government in the form of taxes.
However, if taxpayers are desirous of maintaining their existing standard of living during payment of large taxes, they might put in extra efforts to make up for the income lost in tax.
It is suggested that the effects of taxes upon the willingness to work, save and invest depends on the income elasticity of demand. Income elasticity of demand varies from individual to individual.
Suppose the income demand of an individual taxpayer is inelastic. In that case, a cut in income consequent upon the imposition of taxes will induce him to work more and to save more so that the lost income is at least partially recovered. On the other hand, the desire to work and save of those people whose demand for income is elastic will be affected adversely.
Thus, we have conflicting views on the incentives to work. It would seem logical that there must be a disincentive effect of taxes at some point, but it is unclear at what level of taxation that crucial point would be reached.
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