How do taxes serve public policy objectives?

Firstly, taxes can be used to redistribute income and wealth if the existing distribution is considered to be too unequal. Many developed countries have experienced much more inequality in income and wealth in recent decades. For example, in the OECD group, which consists of mainly developed economies, in 2011, the average income of the richest 10% of the population was about nine times that of the poorest 10%. The Gini coefficient, a standard measure of income inequality that ranges from 0, when everyone has identical income, to 1, when all income goes to only one person, stood at an average of 0.29 in OECD countries in the mid-1980s. By 2010, however, it had increased by almost 10% to 0.32.

Progressive tax rates on income and wealth can be used to reduce the post-tax levels of income and wealth. On its own, such measures don’t benefit the less well-off, so a redistribution policy requires transfers from government to its citizens, either in money form, welfare and social security benefits, or in kind, such as education or health care. High rates of tax on income and wealth, however, can damage economic performance, as they reduce incentives to invest, set up businesses, and bear risk. Another area of public policy where taxes can play a role is in the area of public health. Consumption of products such as alcohol and tobacco can be harmful to health and also increase health care costs.

An indirect tax on such products increases the price to users of these products, and this will reduce demand and help to improve health outcomes and reduce health care costs. The revenues from such a tax can help to pay for such costs. But what’s the impact of such a tax on consumption? This depends on how sensitive demand is to a change in price, what economists call elasticity of demand. As alcohol and tobacco are habit-forming, demand may be very insensitive and so might require a substantial increase in tax to bring about the desired fall in consumption. So such a policy is often accompanied by regulation, such as package labelling and restrictions on advertising or on sales to minors.

A final example of the role of tax in public policy is that of climate change and global warming. Activities that contribute to emissions of carbon dioxide, such as the burning of fossil fuels to produce electricity, can be taxed - sometimes called a carbon tax - to discourage such emissions and create incentives

to use other sources of power: renewables, such as the sun, water and wind power. However, the science of global warming is subject to a degree of uncertainty and is disputed by some. It is also a global problem and needs international cooperation to raise such taxes. The problem here is that unless all countries agree, individual countries will see an advantage in not levying such taxes.