What is the relationship between taxation and production?

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The question asks about the relationship between taxation and production. This should be discussed at two levels. The first level is the analysis of short-run, microeconomic effects. At this level, microeconomic theory shows that increased taxation as the effect of raising prices, with the result of declines in production and amounts demanded. In general, this would lead to the macroeconomic effects of lower employment. The ultimate distribution of effects between producers and consumers will vary by market, and be determined by the relative elasticities of supply and demand for those markets.

The second level is more complicated, namely, the effects based on what the taxes are used for. That is, taxation does not occur for its own sake, but rather to finance governmental activity. Much of that activity is essential for production to occur, especially that activity which supports a legal system which allows commerce to occur efficiently. Few things impede efficient production like anarchy and fear. Additionally, commerce and production benefit from effective physical infrastructure and a well-developed educational system, all things which are frequently supported by governmental action. Quantifying the relationship between these activities, the amounts spent on them, and the benefits to production is difficult, however, and many times the decisions regarding allocation of tax revenues are driven by political motivations as much or more so than economic ones.

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