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Skip to 0 minutes and 19 secondsTaxes have distortionary effects on the choices of consumers and producers. Taxes on goods and services can reduce the demand for these products and can encourage a switch to products to carry no or less tax. Taxes on income may encourage taxpayers to work for cash so as to lower their reported earnings to the tax authorities. We call this the shadow or informal economy. Or they may encourage people to work fewer hours and enjoy more leisure time. Higher taxes on the income from savings may encourage savers to save less for the future and enjoy more consumption today. Sometimes, governments use these effects to encourage or discourage certain activities. For example, lower taxes on corporate profits for certain types of investment spending.

Skip to 1 minute and 10 secondsTo avoid too much distortion, some governments find it preferable to widen the tax base. That is, to levy taxes on as wide a range of incomes, wealth and spending as possible so that individual tax rates are low. In this way they can minimise these distortionary effects. Governments that borrow to finance their spending face the inevitable need to repay these at some point in the future. It may make economic sense to borrow to finance investment spending on, for example, infrastructure. Since these assets have durability and, to the extent they improve future economic performance, they may be paid for out of the additional tax revenues that arise from the economic growth.

Skip to 1 minute and 57 secondsBut borrowing to finance current spending, say, to pay the wages of public officials, leaves no such future assets, but still leaves governments with the problem of repayment. This may require higher taxes in the future.

Skip to 2 minutes and 17 secondsGovernments that rely predominantly on export earnings for their revenues from natural resources, such as oil, gas and minerals, can face particular problems. These revenues arise from the sale of licences to explore and exploit, as well as taxes on these activities. The resulting problems from this have been called the resource curse - an over-reliance on these revenues to the detriment of investment in other, more technologically-advanced sectors. They can lead to corruption by politicians and government officials who benefit personally from their exploitation. And their export subsidies can drive up the exchange rate of their currencies, making other sectors uncompetitive and providing another reason for neglecting them. We'll be examining this in more detail later in the course.

What are pros and cons of alternative sources of revenue?

As well as taxation, governments also raise public revenues through borrowing and export earnings. However, there are challenges to these approaches.

Here, Professor Tony Allan outlines the drawbacks of alternative sources of revenues.

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This video is from the free online course:

Understanding Public Financial Management: How Is Your Money Spent?

SOAS University of London

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