In the previous article, we have studied the concepts of the tax base and tax rate individually. Now, it is time to see how the two react. We already know the basics to some extent. We know that the tax base and the tax rate move in opposite directions. Hence, ideally, if we increase the tax rate, the tax base will decrease, and vice versa.

In this article, we will have a closer look at this relationship and move on to the concept of elasticity of taxes.

Elasticity of Taxes

Decisions regarding corporate tax policy are made based on this relationship. The degree to which the increase in the tax rate causes a change in the tax base is called the elasticity of taxes. The concept of elasticity is very old in economics. It has been prevalent right since the time of Adam Smith when the principles of elasticity of demand were discussed.

However, when it comes to taxation, elasticity was not paid much attention to. In taxation, economics elasticity is a very recent phenomenon. However, it is quite important for a government that is looking to maximize tax revenues. We can classify taxes into three different types based on the elasticity.

Inelastic Taxes: These are taxes where a change in the tax rate has little or no effect on the tax base. Taxes levied on sin goods such as cigarettes and liquor generally fall in this category. Since the demand for these products remains more or less unchanged, increasing the tax rate leads to an increase in the tax revenue.

Unitary Elastic Taxes: These types of taxes are just theoretical constructs. They do not actually exist. As per the theory, the percentage change in the tax rate is exactly offset by the percentage change in the tax base. Hence, a 10% increment in the tax rate will cause a 10% decrease in the tax base. Since the tax revenue is the product of tax rate and tax base, it remains unchanged. The increase in one is exactly offset by the decrease in the other.

Elastic Taxes: Elastic taxes move in the opposite direction. Here increasing the tax rate lead to a decrease in the tax base. However, the percentage of both may vary. For instance, a 5% increase in the tax rate could lead to a 10% decrease in the tax base. Other times, a 10% increase in the tax rate could lead to a 2% decrease in the tax base. In such situations, raising taxes would be beneficial for the organization.

Principles of Tax Elasticity

The relationship between tax elasticity has been extensively studied in recent years. Many generalizations have been drawn in recent years. Some of them have been mentioned below:

• Tax elasticity is thought of as being more prevalent at higher rates. This means that when tax rates are first increased, the tax base isn’t negatively affected. However, once the rates go higher, the negative impact on the tax rate becomes more apparent

• Secondly, the elasticity of tax rates is observed more in the long run. This means that if taxes are raised for short periods of time by the government to make some quick money, the impact is not that severe.

Why is Elasticity of Taxes Difficult to Measure?

The concept of elasticity of taxes has taken a long time to penetrate into economic literature because of the following reasons.

• Based on Potential Income: When a government raises corporate tax rates, companies do not abandon the factories that they are already operating. Hence, the effect of the tax rates is not visible unless the hike is dramatic. However, the growth rate of future tax is impacted. For instance, companies do not do any type of expansion activities once the tax rate has been increased. Instead, the same companies start outsourcing the work to lower tax companies. Also, when the factories and the equipment are depreciated, companies do not replace them. Hence, the effects of elasticity are observed only when the growth in potential tax revenue is taken into account.

• Longer Time Periods: Demand elasticity is apparent because people stop buying goods as soon as the price is raised. However, as mentioned above, corporations have already invested a significant sum of money, which represents a long term commitment. Hence, they do not make decisions quickly. Corporate decisions to move out typically take a few years. Hence, the cause-effect relationship is not readily apparent.

• Effect of Competition: Lastly, the concept of elasticity has become more prevalent now with tax competition. Companies can move out to other countries with lower tax rates because of the opening of political borders. The free movement of goods and services has played an integral part in this elasticity.

• In the globalization era, the free movement of goods and elasticity was restricted. Hence, companies had a choice between continuing operations and shutting them down. They would stop operations only when the marginal costs exceeded marginal revenues. However, in this era of tax competition, companies have more choices.

The bottom line is that the concept of tax elasticity is very important. Very often, there are political debates in countries that have high debt. In such debates, the idea of raising the tax is often floated in order to increase revenue. However, now since we know about the elasticity of taxes, we know that raising taxes can sometimes lead to a fall in revenue as well.