What Are Induced Taxes?

Induced taxes are a type of tax that rises or falls according to an economy's real gross domestic product (GDP) changes. They are intended to induce taxpayers to do one of two things: spend money if the economy is down or save money if the economy is stable.

Induced taxes are also a tool used by the government as an automatic economic stabilizer. For example, when the level of real GDP falls substantially—indicative of an economic recession—the government can reduce taxes to help spur economic growth.

Key Takeaways

  • Induced taxes are a type of tax that rises or falls according to an economy's real gross domestic product (GDP) changes.
  • They are intended to induce taxpayers to do one of two things: spend money if the economy is down or save money if the economy is stable.
  • Induced taxes are also a tool used by the government as an automatic economic stabilizer; these types of economic policies and programs are designed to offset fluctuations in a nation's economic activity without intervention by the government or policymakers.

How Induced Taxes Work

Real GDP is also known as the constant price or inflation-corrected GDP; it is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year.

The real GDP accounts for changes in the price level and it can provide a more accurate figure of economic growth. Because of the positive relationship between induced taxes and real GDP, governments sometimes raise taxes in a healthy economy in order to capture additional revenue. The converse situation is also sometimes true. In a slow economy, governments may lower taxes in order to help stimulate consumption.

Induced taxes are a tool used by governments as an automatic economic stabilizer. These types of economic policies and programs are designed to offset fluctuations in a nation's economic activity without intervention by the government or policymakers.

Induced taxes can stabilize economic cycles and automatically, without explicit government action. If done effectively, induced taxes are used by governments so they will not have to take direct action. Theoretically, by reducing taxes in the short term, an economy's consumption expenditure will increase, causing a rise in the short-term GDP.

When the incomes of individuals increase, so do their tax liabilities. At the same time, eligibility for government benefits decreases. All of this occurs without any changes in the tax code or any other legislation. Similarly (but conversely) when incomes decrease, so do tax liabilities. At the same time, more families become eligible for food stamps and unemployment insurance—benefits that help support taxpayer's income. Reduced income and taxes can offset any declines in the GDP.

In fact, the Congressional Budget Office estimated that through increased transfer payments from the government—specifically unemployment—and reduced taxes, automatic economic stabilizers were responsible for stimulating the economy during (and in the aftermath) of the Great Recession between 2007 and 2009, and thereby helped strengthen economic activity. The total stimulus was equal to more than $300 billion annually in 2009 through 2012, an amount equal to or exceeding 2% of potential GDP in each year. (Potential GDP measures the maximum sustainable output of the economy.)