Finance and financial system

THE MAIN FUNCTIONS OF TAXATION IN

A FREE MARKET ECONOMY

Ex 1. Comment on the meaning of the following words and word combinations:

government budget

to generate government revenue

transfer of resources

necessary reallocation

government financing

fiscal policy goals

social policy purposes

implementing the particular programme

purchasing power

innovative development

household

ration

foregone

imply

 

THE MAIN FUNCTIONS OF TAXATION IN A FREE MARKET ECONOMY

Public sector purchasing agencies have to buy goods from companies and pay wages and salaries to public sector employees, and they need funds for this. In a free market economy, tax revenue is the normal way of financing the government budget. The traditional financing function of taxation is to generate government revenue.

Economically speaking, the provision of public goods for a given level of macroeconomic resources is only possible through foregone consumption of private goods. This further implies that the transfer of resources from the production of private goods to the production of public goods involves a corresponding restriction of household demand in the markets for consumer goods. Economically, the government can only dispose of resources in the form of commodities if the private sector has previously renounced its claims to commodities. As a free market economy permits neither government rationing of the supply of consumer goods, government price fixing nor government financing through the printing presses, the necessary resources can only be made available through taxation. Taxation thus has the basic economic function of skimming–off private sector purchasing power. This levy on consumer purchasing power is ultimately the only way the state can enforce its claim on resources i.e. the necessary reallocation from the private to the public sector.    

In terms of establishing an optimal macroeconomic mix of commodities, taxation acquires further economic functions in reallocating resources. The fact that production or consumption of specific goods or example, petrol consumption by cars – results in unacceptable environment pollution demonstrates the need for the government to act on environment issues. The actual cause of the environment problem is that companies of consumers do not factor the adverse impact of their economic activities in as a cost. This means that the market prices of commodities which result in environmental pollution are too low in comparison with those of other commodities. This market failure can be corrected by the state bringing about the necessary increase in the prices of goods which result in environment pollution through specific taxes. In Western European countries such tax–based environment policies are the subject of increasingly lively debate.

The fiscal policy goals in connection with maintaining or establishing the effectiveness of market processes refer to government promotion of technological and innovative development, competition, establishment or conversion to new forms of corporate organization and economical use of exhaustible resources. Basically, this involves phenomena in the domain of market failures. Taxation could also assume a directly economic function to eliminate or reduce such phenomena by rewarding desirable trends through tax concessions. However, goals of industrial promotion can be much better attained through investment grants than through tax concessions. An economy’s attractions, in terms of resources, as a location for industry would, for example, be much more effectively enhanced through company taxation which was neutral towards investment and free of distortionary features than through unilateral tax concessions for foreign investors.

The fundamental functions of taxation naturally include the redistributive function which is generally acknowledged both in theory and practical policy-making. This involves the provision of assistance for social policy purposes. Taxation concerned with redistribution inevitably raises the question of compulsory contributions to a national social security system.

Finally, there is the general political function of taxes in a democracy. The basic question here is the fact that competition between political parties for votes takes the form of alternative programmes for government spending and taxation. The general political function of taxation then involves providing every voter with as much information as possible about the personal burdens involved in implementing the particular government spending programmes.