Induced Taxes Definition

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Induced Taxes Definition

What Are Induced Taxes?

Induced taxes are levied as a fraction, rate, or percentage of income, expenditure, or profits, such that an increase in income, spending, or earnings causes a proportional increase in the amount of the tax. In Keynesian economics, induced taxes work as automatic stabilizers, reducing aggregate demand during booms and increasing aggregate demand during contractions and recessions.

Key Takeaways

  • Induced taxes are a sort of tax that increases or lowers in response to changes in income, expenditure, or profits.
  • In Keynesian economics, induced taxes serve as automatic economic stabilizers.
  • In principle, induced taxes, together with other automatic stabilizers, should serve to stabilize macroeconomic performance.

Understanding Induced Taxes

Deficits in aggregate demand, according to Keynesian macroeconomic theory, may lead to economic recessions, and one of the key goals of government economic policy is to combat these recessions and, more broadly, to smooth out economic ups and downs. Automatic stabilizers are a common tool for doing this.

Automatic stabilizers are existing laws, levies, or other policy measures that stimulate aggregate demand during sluggish economic times and rein in aggregate demand during periods of excessive economic growth, and do not need any new legislation or policy changes to work. Induced taxes are a kind of automated stabilizer.

Proportional or progressive taxes on personal income, expenditures, or corporate earnings are examples of induced taxes. Because these taxes grow (or decrease) in lockstep with the underlying activity being taxed, they mitigate the impact of variations in economic activity on aggregate demand. In Keynesian terminology, they lessen the multiplier impact that increases in spending or income have on GDP (GDP).

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Example of Induced Taxes

For example, a 10% income tax generates induced taxes equal to 10% of the increase in income. Income earners maintain the remaining 90% of their extra income to spend or invest, which may enhance aggregate demand by 90% of the additional income.

Without the 10% tax, income earners would be able to spend—or invest—the whole gain in income. The induced tax lessens the influence of rising income on people’s capacity to spend and invest more, hence diminishing the impact of rising income on growing aggregate demand and consequently economic development. This, according to Keynesian theory, may assist to avert an overheating economy and increasing inflation.

On the other hand, if an economic downturn or negative economic shock occurs and income declines, the overall amount of income taxes paid lowers as well, due to the 10% income tax. Because the remaining 10% represents induced taxes that the income earners no longer owe, after-tax income only falls by 90% of the income loss. According to Keynesian theory, this will tend to mitigate the negative effect of income declines on aggregate demand and GDP, so cushioning the blow of a recession.

Types of Induced Taxes

Sales taxes, value-added taxes, investment taxes, and taxes on corporate income and profits all have a comparable impact on consumer spending and business investment. Progressive tax rates may have an even stronger stabilizing impact, particularly on big changes in income or expenditure.

Because induced taxes lower the swings in aggregate demand and GDP on both the upside and downside of economic cycles, they should, in principle, reduce the overall volatility of macroeconomic performance, together with other automatic stabilizers such as unemployment insurance.

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