- While many would argue that it is a government’s obligation to ensure that its citizens enjoy a “reasonable” standard of living, this is a problematic issue for many reasons, not the least of which is the question of what constitutes a reasonable standard!.
- As to be expected, economists who support a classical point of view tend to argue against the active role of government in redistributing income. They believe it interferes with market forces and results in inefficiencies.
- The neo classical view argues that the optimal allocation of resources occurs in free markets and so government taxation must be kept to a minimum.
Neo Classical Perspective Redistribution of Income - If firms have to pay insurance and social security costs for workers, then this will encourage firms to hire few workers, thus contributing to unemployment.
- High taxes in a country might discourage entrepreneurial activity and even encourage entrepreneurs to leave a country in search of more “favourable” tax climates.
Neo Classical Perspective Redistribution of Income - High taxes have negative effects on overall growth in the economy due to the disincentive effect.
- Lower taxes will encourage economic activity leading to an overall increase in output that will be to the benefit of all people.
Taxes and the Neo Classical Perspective - Economists promoting a free market view might argue that taxes should be used to finance the obligations of the government to ensure property rights, reduce the effects of market failure, provide effective security and judicial system and promote competition.
- However taxation should not be used to redistribute income.
THE LAFFER CURVE (HL Concept) - The view that higher direct taxes create a disincentive effect and ultimately a negative effect on government revenues became popular in the 1970s as a result of the work of American economist Arthur Laffer (Supply side free market economist)
- Laffer developed what is now known as the Laffer Curve to illustrate the relationship between direct taxes and government revenue.
DIRECT TAXES & THE LAFFER CURVE
If the direct tax is 0%, then the government would earn no money in tax revenues. If the direct tax rate is 100%, then there would be no incentive to work and thus there would be no income for the government to tax. The points in between reflect the view that ultimately higher direct taxes will cause people to work less hard, thus earning less income and paying less in taxes. According to the theory an increase in the direct tax rate from a% to b% will result in higher tax revenues. However, a further b% to c% would lead to a fall in tax revenue. It follows that if direct tax rates are above b%, (at c% for example), the government could increase tax revenue by reducing the direct tax rate, thus giving people an incentive to work harder.
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