There are many negative impacts of taxation in the economy, and that is why taxing business and individuals too much can easily lead to a decline in productivity.
It May Discourage Hard Work
In an effort to redistribute income from the rich to the poor, the government might find itself discouraging people from working hard to become rich, since with increase in income, the greater will be the increase in taxation.
For example, if someone knows that beyond a certain level of income, he will pay the government an extra 50 cents for every extra dollar he earns, he may be discouraged from becoming more enterprising. In the long run, this will reduce the productivity of the whole economy.
May Discourage Saving Habits
Since direct tax falls on income and not consumption, individuals may be penalized for saving money and investing it. Take a case where two people are earning the same amount of income during there working years. If each one of them earns $1,000,000 during their active years, they will be required pay the same amount of tax like $100,000. If one person decides to save and invest $200,000 and the other person decides to save and invest $100,000, the first person would have consumed less during his active years compared to the second person. If both persons earn then same amount of interest on their investments, the first person will earn more and taxed even more, and the second person will earn less and be taxed less. From this, you can see that someone will be tempted to avoid saving because there is actually no reward for saving money.
It May Discourage Foreign Direct Investment
Foreign investors look for opportunities to make money. For this reason, they are always looking for places or locations that are favorable to them. These are the locations that give them the chance to achieve their plans. High taxes may discourage investors from going into a particular country as these taxes will obviously eat into the income of the business entity.
With increased globalization, different countries aim to attract investors through a variety of measures such as reducing taxes and so on. It is therefore very easy for a company to move from one country to another simply because of the tax incentives offered in another country.
As people continue to debate about the importance of taxation and the negative effects of the same, it is important that governments understand that that although tax increases may seem beneficial in the short-run, they may end up being counter-productive in the long-term.