Why Do People Pay Taxes?

People pay taxes so that their government can spend it. To understand why people pay taxes we must understand what governments spend the tax income on.

To understand the role of government spending and its impact on an economy, we have to first understand: from where does the government earn its money and how does the government spend its money? There are two main sources for the government to earn its money.

The first, and the biggest source are taxes. The government taxes a lot of things, such as income of individuals via income tax, profits of corporations by corporation tax, and host of several indirect taxes like sales tax and service tax. These taxes together contribute the biggest source of income for a government.

coinsThe second source of income for the government are non-tax revenues. These are income where the gap which the government makes from its public spending. So, for example in India the Indian government owns the Indian Railways so any profits made by the Indian Railways is a source of revenue for the government. Similarly the government is a shareholder in several banks. When these banks make profits and pay dividends, that is a source of revenue for the government.

Where does a government spend its money?

It is possible for economists to be able to classify government spending into two different, but linked categories, that would be expenditure on revenue and expenditure on capital.

Revenue expenditure is the expenditure the government has to incur to functioning. So, for example paying salaries of government employees, allocation of money to ministries. So, all these are part of the expenditure which the government has to spend to function.

There is the other sort of expenditure, capital expenditure. Capital expenditure is a bit different because this leads to assets in the economy. When the government spends money to build roads, bridges, railways, hospitals, or schools this traincan be seen as capital expenditure, because this is leading to asset formation.

What is a deficit?

It so happens that in certain years the government spends more money than it earns. When this happens the question is: from where does the government get that extra money? Hypothetically speaking, if the government earns one hundred from taxes and spends 150, from where does the government get that 50? The answer is that the government essentially borrows that money.

It can borrow the money from the Central Bank. Or, they can borrow directly from the market. When the government spends more than it earns, when the revenue expenditure and the capital expenditure is more than what the government earns, the government is known to be running a deficit. If fiscal deficit if kept in check is not necessarily a bad thing because if the government is mostly spending money on capital expenditures, even though it is running a deficit the government is playing the role of creating assets in the economy.

High fiscal deficit

However, if the fiscal deficit is not kept in the check, and if the government spends way too much money than what it earns, then things can get a bit problematic. Let us understand what problems can a government face, or what problems can an economy face, because of a very high fiscal deficit.

The problems that an economy faces are; high inflation, higher interest rates, and in some cases higher taxes because of high fiscal deficit. Let us understand each of them one by one.

Let’s talk about high inflation. First, when the government borrows money from the Central Bank then the bank has to print new money to lend it to the government. If the central bank prints new money and lends it to the government this increases the total money supply in the economy and the goods and services remain constant. The increase in money supply will cause an increase in prices, so this leads to high inflation.

Secondly, because the government is spending a lot of money this increases aggregate demand in the economy. If for some reason the supply cannot increase to match up to that aggregate demand, then the prices will increase. There could be certain factors which might be inhibiting the economy from increasing its supply. Because of certain constraints and the factors of production. In such a scenario, if the government is spending a lot of money it is increasing the aggregate demand.

High interest rates

Let us take the case of high interest rates. How does fiscal deficit cause higher interest? if the government of does not borrow from the Central Bank, but borrows from the market directly, the government issues bonds in the market they are acting as a source of investment. For many investors out there, when investors see governments issuing bonds some of the investors might be willing to invest in that government. The government is therefore competing against the other sources of investments that are there in the economy; the fixed deposits, the post topic savings, are the deposits by banks, so all these other sources of investments have found a new competitor. When the government enters the market and try starts selling its bonds these other sources of investments need to keep their customers with them so they have to pay a higher interest rates.

If the cost of capital starts increasing, for a lot in the economy that can be problematic. For economic growth; because cheap capital is something that is necessary . If capital becomes expensive that will hinder investments because people might not be willing to borrow money and hence investment opportunities will become scarce because capital has become expensive. The economic growth in the country takes a hit.

money rollThis is how we saw where fiscal deficit causes high interest rates, which can in certain cases have detrimental effect on the economy. In certain dire situations, where the government is running a very high official deficit, then the government might be forced to increase their taxes to increase their income. If so, the government is forced to increase the taxes on their citizens or on the economy to increase its income. Increase in taxes can have several cascading effects.

The effects of increases in taxes

it can affect consumption levels, it can affect investment decisions, and hence that can also in some cases have detrimental effects on the economy. We see that this fiscal deficit figure is very important, because very high fiscal deficits has detrimental effects on the economy.

If fiscal deficits become uncomfortably high, the government will then start taking measures to bring down their fiscal deficit. In an economy, the government plays a very critical and crucial role. The first of them isĀ  it is the onus of the government to provide a well-functioning legal and political system.

An economy, a government, or a society which is experiencing political turmoil is not conducive for economic growth because there is very little trust in the system; there is a lot of uncertainty and people are unwilling to invest. Governments need to make sure that the country has a stable political environment which is very important for the confidence level required for people to invest and increase the economic activity. A government must provide a good legal framework, because when people invest or enter into contracts with each other they are bound to be cases where certain counterparties renege on their promises. Therefore, contract enforcement becomes very critical in a developed economic world.

It is also the onus of the government to provide such a contract enforcement mechanism via the legal framework, so this providing a well-functioning legal and political system is very important. Secondly, the government plays the other crucial role of being the regulator, and to provide a competitive marketplace. Markets are not completely free, as some free market philosophers think. These thinkers would like it to be so that there needs to be certain checks and balances put in place. There needs to be a certain amount of regulation to ensure that the economy or the society does not drift towards monopolistic situations. There needs to be a proper regulatory framework as well regulation in certain sectors, like the telecom or insurance ones.

Foreign Trade

The government also needs to think about policies when it comes to trade with foreign countries. National economic policies are that the government also decides on the the regulation to put on the natural resources available in a particular country. The regulatory role is also critical when it comes to the economic environment, in a particular country the government regulates the marketplace and tries to ensure a healthy competitive marketplace for the goods and services. In certain cases it is important that the government stimulate the economy by increasing spending.

This was one of the philosophies which was put forward by the renowned economist John Maynard Keynes. He saw that the government’s role becomes very critical in situations where the economy is in recession or is always suffering from a depression. In this case, he argued that the government should increase their spending to pick up the economic activity in a particular country.

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