It has been published by Rachit Garg.
Table of Contents
To run the country’s economy, every government imposes a certain tax so that the government can generate some funds for the nation’s progress. All the infrastructural developments, public services, production, and consumption of the country, including the distribution system, depend on these taxes.
Inflation is another parameter that has evolved as a result of various taxes. Therefore, it is very essential to understand how these two economic parameters are interrelated. Understanding this relationship will help not only government policymakers but also the general public as a whole.
Therefore, in this article, let us understand the benefits of taxation and its detrimental effects on the economy.
What is taxation
Before understanding the relationships between taxes and inflation, let us first develop a conceptual understanding of taxation. No matter what country you live in, any country’s government will introduce certain taxes on its citizens, various businesses, or any other agencies that are capable of generating revenues.
Taxes can be in several forms, and some of the common forms of taxes are:
- Income taxes
- Consumption taxes
- Property taxes
- Corporate taxes
- Entertainment taxes
Taxes have existed ever since people became civilised, and whoever ruled the country or a state introduced taxes in some form or another. People have been paying taxes to designated government officials in the form of money or some other means appropriate during that period.
Types of taxes
Let us try to understand the above types of taxes individually:
All of us will try to earn our income to buy the necessary items to run our house. The government will generally impose a particular tax on our income in the form of an income tax. This tax will, however, depend on our earnings. The higher the income, the tax will also be higher.
Government policymakers will create a threshold limit beyond which your income will be taxable. If your income is meagre, then there may not be any tax on your income. The government will decide this threshold limit based on the rate of inflation.
There are a few consumption taxes that most of us are familiar with, such as VAT (Value added tax), sales tax, etc., that we have been paying to the merchant when we buy any products or services.
Often, these taxes can be too high for many of us, so our buying power can be severely impacted due to such taxes.
Most of us have a house to live in, which is termed property, and the government can also impose a particular tax for owning such property, which will depend upon the market value of that property.
All state governments in India impose such a property tax on the property owners, which is one of the primary sources of revenue for the respective state governments. Often, such taxes can be high, too.
Those who are business owners may earn profits from their businesses, where the government will impose a tax, which is known as corporate tax. The respective states of the country decide the rate of such taxes.
The investments made by businesses often depend upon this corporate tax, which is one of the factors in the country’s economic growth.
Another form of tax, called entertainment tax, is imposed on us when we enjoy any of the following:
- Sporting events
- Streaming videos on TV
The state government also decides on this tax. The government can often waive off this tax if they find that such entertainment may be promoted to educate the masses or benefit the country’s progress. This is another indirect form of taxation.
What is inflation
There can be a rise in prices either due to taxation or several other reasons that may affect the consumer’s buying power, which is known as inflation. The government must consider this important economic parameter, which can seriously influence the country’s economy.
In a situation where inflation is too high, the reserve bank may intervene and analyse the economic condition to control inflation.
Let us take a simple example here to simplify this concept of inflation. When we go to the market to buy our foods, clothes or other essential items, we suddenly find that our money is insufficient to buy as much as we used to. Whether renting a new house or buying a new car, prices are much higher than before. This is because of inflation.
However, it is essential to understand that inflation can offer both advantages and disadvantages.
Advantages of inflation
Advantages of inflation:
- Inflation can fuel growth in a country’s economy.
- Inflation can provide you with an opportunity to ask your employer for a salary hike.
- When there is moderate inflation, prices of the different commodities can be adjusted.
- The inverse of inflation is deflation. Inflation will prevent deflation, as it can create a recession in the country.
Disadvantages of inflation
Disadvantages of inflation:
- The purchase value of your money decreases.
- If your employer does not give you enough raise, then it becomes difficult for you to buy your essential items.
- Businesses tend to avoid making any investments.
- The country’s competitiveness in the international market is affected negatively.
- Inflation can negatively affect a country’s economy if it is beyond control.
What are the effects of taxes on inflation
Now let us discuss here how inflation can exert several impacts on taxation. Many of you must have experienced this, too, when you got a raise in salary due to inflation, and as a result, you will find that you are pushed into higher tax brackets and you may end up paying more income tax.
You may often wonder whether you should be really happy to get your raise, as your net income has not appreciated as much as the price rise that you are facing. Particularly for people who have fixed incomes, inflation may force them to struggle as they are paying higher taxes.
The relationships between taxation and inflation can be quite complex to understand. Taxation sometimes reduces inflation too. When the government imposes taxes to fuel economic growth and create infrastructure and public services, it can reduce inflation
On the other hand, if taxes result in non-growth-related government expenditures, then it may end up with deficits and increased borrowing. As a result, it will expand the money supply and cause inflation.
Relationship between inflation and taxes
Let us now discuss a few more examples of how to establish relationships between inflation and taxes.
The government may increase the interest rate
The government will continuously monitor the inflation rate. If it exceeds the desired target, the country’s reserve bank will try to counterbalance it by increasing bank interest rates. By doing this, the money supply will be under control and there will be an increase in borrowing costs. The higher interest rates may discourage too much economic activity and reduce inflationary pressures.
Taxation and monetary policy
One of the significant roles of a reserve bank is to maintain a stable price. Therefore, it is essential that taxation policy resonate with the country’s monetary policy because it may influence inflation. Tax changes may also impact prices and inflation in the short and medium term.
Tax structures can also control long-term economic dynamics, influencing incentives for investment in human and physical capital and labour supply.
Taxation and government spending
Further, governments may control inflation by minimising government spending and tweaking their tax policies. If there are unnecessary expenses without proper control, then the economy may disbalance, and as a result, inflationary pressures will be created in the economy.
Fiscal imbalances may yield budget deficits, requiring the issuing of government bonds, which expand the money supply and risk fueling inflation.
When such a situation develops and the inflation rate keeps changing, the personal property tax valuation becomes too complex. In such a situation, businesses cannot decide the asset’s value based on its type.
As a result, due to increased taxation and production costs, the profit margin will reduce, and there will be no further investments. Inflation can also increase wages and operational costs, squeezing profit margins even further and hindering further business planning and growth.
Impacts the economy
The significant impact of inflation will not only be the reduced purchasing power, but it will also create more wage demand, leading to more layoffs. The national currency value may decrease, making the country’s domestic products less competitive in the global market.
Taxation and inflation policies must strike a balance between revenue generation and economic growth, as high inflation can erode confidence, destabilise the economy, and harm business competitiveness in global markets.
Consumer demand and spending patterns
There is no doubt that taxation will influence inflation and consumer demand. If a higher consumption tax is imposed, it will reduce purchasing power, which may give rise to deflation.
On the other hand, a reduction in consumption tax will produce disposable income, increase demand and affect inflation. Tax rates on essentials like food and fuel significantly affect overall price levels.
Incentives for investment and economic growth
In developing and developed countries, tax concessions are often offered to offset economic growth. A few incentives, like lowering income tax or import duties, are offered.
However, critics often debate whether such gains can justify revenue losses, as lower corporate taxes can also spark inflation if demand is greater than supply.
The relationship between taxation and inflation is quite complex to comprehend. Only economists can understand it better and suggest that the government make policies to counterbalance it. After all, taxation can control the country’s economy by funding various public services, production and distribution systems.
Inflation also has a vital role in the country’s economy, as it can both harm and benefit the economy. A moderate level of inflation can fuel the growth of a country’s economy. However, very high inflation can destabilise the economy. Taxes can play a particular role in controlling inflation.
The country’s government must do a balancing act to manage the economy by developing good economic policies so that inflation remains healthy, government spending can stay under control, and investment by the business community increases. The government policy on taxation and inflation can affect all of us as citizens of the country, businesses and the economy of the country as a whole.
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