Taxes are a fact of life in almost every modern day economy. Amongst other things, the collection of taxes ensures that citizens of a country have a social security net when unemployed. However, there is a line of thought that contends lower tax rates will actually reduce unemployment. In this article, by TaxClimate.com, we explore whether this claim is true…
How Do Tax Rates Affect the Unemployment Rate?
Tax rates are a factor that affects the supply of goods and services. When taxes are high, this increases the cost of production, meaning a higher cost for goods and services. This lowers the amount of goods that a firm is willing to supply.
High taxes also affect the disposable income of consumers, leading to a lower demand of goods and services.
When both the demand and supply in an economy is lower overall, there are less opportunities for employment, and this leads to a higher unemployment rate.
Here is a detailed look into how lower tax rates can increase supply and demand in an economy, to reduce unemployment.
How Lower Tax Rates Increase Demand in the Economy
By increasing demand for goods and services, more workers are employed to meet the increased demand. As a result, this will bring down unemployment.
The total amount of demand for goods and services in a given economy, is made up of 4 things: Consumer spending, Investment, Government spending and the Balance of trade (the difference between exports and imports).
By lowering taxes, a country will be able to influence these 4 factors to increase demand in the following ways:
- Consumer Spending – By lowering taxes, individuals will keep a greater share of their take home pay. This boosts their disposable income and increases spending in the economy.
- Investment – By lowering taxes, firms have more capital available to invest in ventures that will produce further growth. This causes a positive spiral upward of increasing demand, and in turn new jobs.
- Government Spending – Lowering taxes will reduce tax revenues collected in the short term, however, in the long run they will rise from the increased revenue growth of corporations. This increased tax revenue can be used by the government to improve public infrastructure. This will lead to a demand for workers to complete these jobs.
- Balance of Trade – By lowering taxes, companies are better incentivized to keep their funds located within their home country, rather than moving it offshore. Lower taxes also entice capital from foreigners to be invested domestically, if their tax rates are comparatively higher. These two things allow more funds to be invested and spent within the domestic economy.
How Lower Taxes Increase Supply in the Economy
By increasing the willingness of firms to supply goods and services, more individuals are employed.
Lower tax rates can increase the willingness of firms to supply goods and services, in the following ways:
- Increased Incentive to Work – there is an argument that lower income taxes could encourage workers to work more hours, as their take-home pay is increased.
- Improved Technology and Equipment – the tax savings can be spent on improving production equipment
- Improve productivity of workers – Through training and skill development.
As you can see, managing an economy is a complex issue. There are many variables that could affect the unemployment rate, and there is no universal solution for each and every country.
Nonetheless, when executed properly, lowering tax rates can produce positive effects in the economy that can lead to a reduction in the unemployment rate.