Induced Taxes

What Are Induced Taxes?

Induced taxes are taxes applied as a fraction, rate, or percentage of income, spending, or profits such that a rise in income, spending, or profits induces an increase in the amount of the tax in some proportion. In Keynesian economics, induced taxes function as automatic stabilizers, which moderate aggregate demand during expansions and boost aggregate demand during contractions and recessions.

Understanding Induced Taxes

In Keynesian macroeconomic theory, deficiencies in aggregate demand can lead to economic recessions, and a primary goal of government economic policy is to fight these recessions and more generally to smooth out economic ups and downs. One popular tool to go about this is the use of automatic stabilizers.

Automatic stabilizers are standing laws, taxes, or other policy measures that boost aggregate demand during slow economic times and rein in aggregate demand during periods when economic growth accelerates too fast, and do not require any new laws or changes to policies to function. Induced taxes are a common form of automatic stabilizers.

Induced taxes include proportional or progressive taxes on personal incomes, expenditures, or business profits. Because these taxes rise (or fall) along with the underlying activity being taxed, they moderate the effect that changes in economic activity have on aggregate demand. In Keynesian terms, they reduce the multiplier effect that changes in spending or income have on gross domestic product (GDP).

Example of Induced Taxes

For example, an income tax of 10% creates induced taxes when income rises, equal to 10% of the increase in income. Income earners keep the other 90% of the additional income they earn, to spend or invest, and this, in turn, can boost aggregate demand by 90% of the addition to income.

Without the 10% tax, income earners would have all of that increase in income to spend — or invest. By reducing the effect that the rise in income has on people's ability to spend and invest more, the induced tax reduces the impact that the rise in income can have in boosting aggregate demand and thus economic growth. In Keynesian theory, this can help to avoid an overheated economy and accelerating inflation.

On the other hand, if an economic downturn or negative economic shock hits and income falls, then with the 10% income tax the total amount of income taxes being paid also falls. After-tax incomes only fall by 90% of the reduction in income, because the other 10% represents induced taxes that the income earners no longer owe. In Keynesian theory, this will tend to moderate the negative impact that a fall in incomes has on aggregate demand and GDP, softening the blow of a recession.

Types of Induced Taxes

Sales taxes, value-added taxes, taxes on investment, and taxes on business incomes and profits have a similar effect on changes in consumer spending and business investment. Taxes with progressive tax brackets can have an even more powerful stabilizing effect, especially on large changes in income or spending.

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