When it comes to tax strategy, from the view of any level of government, we must think about what we are trying to achieve.

Generally speaking, tax policy has one of three goals. First, to raise revenues to pay for core services that benefit the public at large. Second, to reduce the incentive to perform some action. And third, to influence the level of economic activity for a given time period.

Let’s be clear, taxation will always have these three effects. The question is, “which one of these impacts is the tax designed to achieve?”

We will take a closer look at the implications of tax policy in a later post. For now, let’s focus on the goals the government may have for collecting taxes.

Role of Government

In order for a society to function, some level of governance is required.

At the most basic level, a rule of law creates a framework for society to live by. It informs people of acceptable actions within society. And, it protects individuals from violations of their basic rights.

Without a rule of law, society functions based on natural law. That is to say, rights exist to the extent you can physically defend them.

The rule of law allows a judicial process to step in and defend those rights. This places all people on a much more level playing field.

Establishing and enforcing the rule of law requires the establishment of a legislative body (to make the rules), a court system (to interpret the rules), a police force and corrections system (to enforce the rules), an executive (to manage the system), and a support staff.

Revenue Generation

Additional functions of a government are the prerogative of the legislature to decide. Most developed systems also task the government with things like the management of public resources, ensuring national security, and providing common goods like education and healthcare.

They also provide or support infrastructure that enables a more efficient economic system, like roads, railroads, bridges, ports, airports, communication systems, water, and electricity.

Again, it is the responsibility of the elected officials to decide exactly what the government should do and what should be left to the private economy. But, it should be clear that some level of government is required in order for a society to function.

Therefore, the population must contribute in some way to the general services that they all utilize. The government ensures that participation through taxation.

Tax as a Disincentive

The law of demand simply states that the more something costs, the less of it will be purchased. It follows then that if you tax something (make it more expensive), people will buy less of it.

Occasionally, governments use this economic law to nudge people away from things that they believe are not good for society. The most well-known use of tax in this way is referred to as a “sin” tax.

These taxes aim to reduce the use of things with adverse health effects, like tobacco and alcohol use. Some governments are currently testing this tax application on sugar sweetened beverages as a way to reduce obesity.

The same logic applies to pollution, crime, and other social “bads.” If you drive up the cost of something, less people do it.

Fiscal Policy

Another common reason governments alter their tax rates is to alter the level of economic activity that is occurring. This is one of the “fiscal policy” tools at the government’s disposal (the other one is spending).

When the economy is overheated, the government can cool it down by increasing taxes or decreasing spending (contractionary policies). They do this in order to minimize the damage of the eventual correction that will take place.

On the other hand, governments can temporarily boost economic activity by cutting taxes, giving tax rebates, or increasing government spending (expansionary policies).

In reality, governments rarely use contractionary fiscal policy, but love using expansionary policies. Of course, doing one without the other leads to debt growth, as we have seen at the US federal level for a few decades now.

The “proper” use of fiscal policy is to pay off those debts incurred by expansionary policy with the additional tax revenue generated by contractionary policy once the expansion occurs.

A proactive government can use savings, rather than debt, in the same way. They would simply put money in the bank when times are good and draw off those savings to fend off recessions. These actions are still fiscal policy tools and should be recognized as such.

Locating the Goal

Before embarking on a tax decision, it is important to know what you are trying to achieve. It is also important to recognize that these goals are often competing with one another.

Raising taxes and cutting spending both have negative effect on the economy. We must always consider both effects.

I often hear people tout the economic impacts of increased government spending without considering the negative effects of increased taxation. That is a mistake.

The spending must warrant the taxation on its own merits, and one should not rely on the economy as a place to support their arguments.

Likewise, avoiding taxes because of its effect on the economy, and at the same time advocating spending cuts without regard to its effect on the economy, is logically inconsistent.

A good approach is to start with identifying the goal, then enter a discussion on the best way to achieve it.

If the goal of a tax is to raise some level of revenues to pay for agreed levels of services, the taxing authority should first determine what services the public is willing to pay for.

Then it should design a tax with full consideration of the effectiveness and equity of those taxes.

If instead, the primary goal is to provide economic support during recessionary times, the taxing authority must minimize tax revenues and promote the most spending it can afford.