Question

Explain any five demerits of induced taxes.

Answer 1

Following are the demerits of induced taxes:

1. Fiscal Drag: As the economy expands, national income rises. This automatically drives individuals into higher tax categories, increasing total tax revenue. This leakage of income reduces aggregate demand and has the potential to prematurely restrict economic growth, a phenomenon known as fiscal drag.
2. Disincentive to Work and Invest: Because induced taxes increase in absolute amount (and frequently by percentage) as income rises, they might lower the marginal value of more work. High marginal induced taxes discourage people from working longer hours and firms from making new capital investments.
3. Revenue Instability for Governments: Induced taxes are highly volatile because they are fully dependent on the state of the economy. During a recession, national income and consumer spending fall precipitously, generating a significant decline in government tax revenues. This results in fiscal deficits just when the government needs money for public welfare.
4. High Administration and Compliance Costs: Calculating and collecting induced taxes requires a complicated legal structure and meticulous tracking of revenue, transactions, and profits. This imposes a heavy compliance burden on taxpayers and necessitates large government expenditures on auditing and enforcement.
5. Encouragement of Tax Evasion: As a person's income or business turnover rises, so does the burden of induced taxes, creating a strong financial incentive to hide income. This results in increasing tax evasion, the expansion of the shadow economy, and a loss of potential revenue for public services.