Taxes are compulsory payments made to the government by firms and individuals, and they are implemented to reduce production and consumption levels to the socially efficient level, where MSB=MSC.
Governments should impose a tax that is equal to the marginal external cost (MEC). However, it is difficult to measure the exact MEC and therefore, it is hard for the government to impose the correct amount of tax. This will lead to the problem of overtaxing or undertaxing. Both overtaxing and undertaxing leads to market failure as resources are still not allocated efficiently.
Undertaxing brings the economy closer to the optimal level. However, overtaxing discourages producers from producing and this leads to quantity supplied being lower than expected. This may even lead to multinational companies withdrawing their investments and investing in other countries with lower taxes. This is an undesirable outcome as a new inefficiency is created.
Thus, overtaxing is more problematic.
Yu Ning(:
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When government fails to implement the correct level of tax, this is known as government failure. More on government failure will be covered towards the end of market failure topic. ~Ms Chen
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