Fundamentals

What Taxes Are and How They Affect Economic Freedom

By Daniel Sardá · April 27, 2026

# What Taxes Are and How They Affect Economic Freedom

Taxes are mandatory payments that the state requires from individuals and businesses in order to finance public spending, redistribute resources or modify behavior. They are not a voluntary purchase or a market fee: they are created by law, and failure to comply can lead to sanctions.

In simple terms, a tax is a portion of income, consumption, wealth, profit or a transaction that is no longer under the direct decision of the individual and is instead transferred to the fiscal and budgetary decision-making of the state.

Understanding what taxes are matters because they affect almost everything: net wages, the price of a purchase, the cost of hiring workers, the profitability of a business, the decision to invest, the formality of an enterprise and the real margin of economic freedom.

From a liberal-libertarian perspective, the central point is not to deny that modern states use taxes. The point is more demanding: because taxes are mandatory and affect private property, they must be subject to clear limits, general rules, transparency, political control and rigorous justification.

A tax does not only finance something visible. It also displaces private uses of money: consumption, saving, investment, hiring, entrepreneurship and individual autonomy.

What are taxes?

A tax is a mandatory levy established by law and required without a direct individualized service in return.

That means three things.

First, it is mandatory. The taxpayer does not freely decide whether to pay. The obligation arises when a legally defined situation occurs: receiving income, selling a product, buying a good, owning wealth, importing merchandise or transferring property.

Second, it is collected by a public authority. It is usually administered by the state through a tax agency, treasury, municipality, regional government or national administration, depending on the country.

Third, it is not paid in exchange for a specific individual service. Someone who pays income tax is not buying a specific school, a specific road or an individual police service. The money enters the public budget and is then allocated politically.

The OECD works with the idea of taxes as compulsory, unrequited payments to general government. The word “unrequited” is essential: the benefit received by the taxpayer is not calculated in direct proportion to what that person paid.

The Spanish Tax Agency, in its educational material, distinguishes taxes from other levies precisely because taxes do not require an individualized administrative action in favor of the taxpayer.

In simple terms

If you buy bread, you pay a price because you want the bread.

If you pay income tax, you are not buying a specific service. You are complying with a legal obligation because you received taxable income.

That difference may seem basic, but it is fundamental. In a voluntary purchase, if the price does not convince you, you can refuse to buy. With a tax, the margin of individual decision is much narrower: the obligation is backed by the coercive power of the state.

Taxes, levies, fees and special contributions: basic differences

In everyday language, people often call almost every payment to the state a “tax.” Technically, that is not exact.

The broader word is levy or tribute. A levy is a mandatory payment established by law to finance public needs. Within that category, many legal systems distinguish taxes, fees and special contributions.

Taxes

Taxes are required without a direct individualized service in return.

Common examples include:

The logic of a tax is general: the state taxes a manifestation of economic capacity, such as income, consumption, wealth or the transfer of goods.

Fees

Fees are linked to an administrative action, public service or regulated use that affects the obligated person in a more individualized way.

Simple examples include:

Even so, a fee is not exactly a free market transaction either. The authority defines the conditions, obligation, procedure and amount.

Special contributions

Special contributions are related to a public action that especially benefits certain people or assets.

Example: a public work that increases the value of nearby properties. In that case, the state may charge a contribution to those who receive that specific benefit.

The key point

Not every levy is a tax.

But every tax does share one central trait: it is a mandatory transfer of private resources to the state without a direct individualized service in return.

How taxes work in practice

Taxes do not operate only through an abstract declaration of principles. They operate through concrete rules.

A tax system defines what is taxed, who must pay, what amount is used as the basis for calculation, what percentage is applied, when the tax must be declared and what happens if the obligation is not fulfilled.

Taxable event

The taxable event is the situation that triggers the tax obligation.

Examples include:

Without a taxable event, there should be no enforceable tax. That is why it is a basic concept: it marks the point at which a private activity enters the field of fiscal obligation.

Tax base

The tax base is the economic magnitude on which the tax is calculated.

It may be:

Tax rate

The tax rate is the percentage or amount applied to the tax base.

Simple example: if the tax base is 100 and the rate is 10%, the calculated tax is 10.

Some systems use flat rates. Others use progressive schedules: the rate rises as income or the taxable base increases.

Taxable person and taxpayer

The taxable person is the natural or legal person required by law to comply with the tax obligation. That person may have to declare, withhold, collect, remit or pay the tax.

But this does not always answer the most important economic question: who actually bears the burden?

A store may be legally required to declare VAT. A company may be legally required to pay corporate income tax. An employer may withhold part of a salary. But the economic cost can be shifted, fully or partly, to consumers, workers, shareholders, suppliers or clients.

That difference is called tax incidence.

What taxes are used for according to the state

The most common institutional explanation says that taxes are used to finance the state. That is true, but incomplete.

Taxes usually perform at least four functions.

Financing public spending

The main function is to raise resources for public spending.

That spending may include:

The liberal question is not whether these categories exist. The question is which of them justify fiscal coercion, how much they cost, who controls them and what results they produce.

Redistributing income or wealth

Many tax systems seek to redistribute resources: to collect proportionally more from those with higher income or wealth and transfer resources through services, subsidies or public programs.

The argument in favor appeals to ability to pay, equity and social cohesion.

A liberal critique should not ignore that argument. It should examine its costs: bureaucracy, clientelism, political dependency, disincentives, capital flight, evasion, complexity and the loss of individual control over one’s own resources.

Modifying behavior

Taxes can also be used to incentivize or discourage behavior.

Examples include:

This shows that a tax is not merely an accounting tool. It is also a tool of political power over private decisions.

Sustaining bureaucracies and institutions

Every tax finances not only “services,” but also the structures that administer those services: ministries, agencies, inspectors, courts, regulators, state-owned companies, contractors and programs.

This matters because the state is not an abstract actor. It is a set of institutions with incentives of their own. It can solve real problems, but it can also expand, protect internal interests, capture rents or justify new taxes to sustain structures that no longer perform their function well.

The most common types of taxes

Taxes can be classified in many ways. For a general reader, the most useful approach is to understand which economic base they tax.

Income taxes

Income taxes apply to the income of individuals or companies.

For individuals, they usually apply to wages, professional fees, rents, interest, dividends or capital gains, depending on each country’s law.

For companies, they tax profits or earnings.

Example: a person receives a gross salary. Before receiving the net salary, the system may deduct taxes and contributions. The worker sees a smaller amount in the bank account than the amount initially generated by his or her work.

Consumption taxes

Consumption taxes apply to purchases of goods or services.

The best-known example is VAT, or value-added tax. Although the business declares and remits it to the treasury, the consumer usually sees the tax incorporated into the final price.

Example: you buy a product. Part of the final price corresponds to the value of the good and part to the tax. Legally, the store may declare it; economically, the buyer may bear a significant share of the burden.

Wealth taxes

Wealth taxes apply to the possession or accumulation of assets.

They may fall on real estate, vehicles, net wealth, large fortunes or other assets, depending on the country.

These taxes create a special tension with private property because they do not tax only a new flow of income, but an accumulated stock. In some cases, that wealth was already formed with previously taxed income.

Inheritance taxes

Inheritance taxes apply to the transfer of wealth by inheritance or gift.

Those who defend them usually argue that they reduce wealth concentration and promote equality of opportunity. Those who criticize them point to double taxation, harm to family saving, forced liquidation of assets and erosion of the right to transfer legitimately acquired property.

Taxes on businesses

These include taxes on profits, payroll charges, labor-related levies, municipal fees, sector-specific taxes and compliance obligations.

Political language often says that “the company pays.” But a company is not a magical entity separate from people. It is a network of workers, consumers, shareholders, suppliers, creditors and clients. The burden may be distributed among them.

The Tax Policy Center explains this issue in the case of the corporate income tax: the burden may fall, depending on the context, on shareholders, workers or owners of capital more generally. The point is not that it always happens in the same way, but that economic incidence may differ from legal obligation.

Tariffs and import taxes

A tariff taxes the entry of foreign goods.

Legally, it may be paid by the importer. Economically, it can end in higher prices for consumers, less variety, less competition and protection for less efficient local producers.

Tariffs are often presented as a defense of national industry. From a free-trade perspective, however, they are also taxes on consumers and barriers to voluntary cooperation among people in different countries.

Direct and indirect taxes

Another important distinction is between direct and indirect taxes.

What are direct taxes?

Direct taxes apply to direct manifestations of economic capacity, such as income, profits or wealth.

Examples include:

They are called direct because the obligation is more visibly associated with a concrete person, company or asset.

What are indirect taxes?

Indirect taxes apply to indirect manifestations of economic capacity, such as consumption, the circulation of goods, imports or transactions.

Examples include:

The Spanish Tax Agency uses this educational distinction between direct and indirect taxes to classify different levies.

Why this difference matters

The distinction matters because taxes do not affect economic decisions in the same way.

A tax on income may reduce the incentive to work more, declare more income or invest in taxed activities.

A tax on consumption may make products more expensive and reduce purchasing power.

A tax on wealth may affect saving, capital accumulation and decisions about residence or investment.

A tariff may temporarily protect some producers, but it makes imports more expensive and reduces consumer options.

The person who legally pays a tax is not always the person who bears it

This is one of the most important ideas in the article.

Legal incidence indicates who must declare, withhold, collect or pay the tax according to the law.

Economic incidence indicates who actually bears the final cost.

They are not always the same person.

The law decides who remits the tax. The market, after adjustments in prices, wages, margins and profitability, determines how the economic burden is distributed.

In simple terms

The law may say: “the company pays.”

The economy may show that part of the cost was shifted to higher prices, lower wages, less hiring, lower returns for shareholders or less future investment.

That does not mean the full tax is always shifted. It means that looking at the tax form is not enough to know who bears the tax.

VAT example

A store sells a product and charges VAT. Legally, the store may be required to declare it and remit it to the treasury.

But if the final price rises, the consumer bears part or all of the burden. If the store cannot raise prices because it would lose customers, it may absorb part of the tax through lower margins. If margins fall too much, it may invest less, hire less or close.

The real burden depends on competition, demand, substitutes, margins and capacity to adjust.

Business example

A government raises the tax on business profits.

On the surface, “companies pay.” But the company may respond in several ways:

There is no single rule. But there is an analytical rule: companies are legal channels of payment, not final subjects separated from all human economic activity.

Worker example

A payroll tax or contribution may appear as an employer cost. However, if hiring becomes more expensive, part of the burden may fall on the worker through lower net pay, lower future wages, less formal employment or fewer labor benefits.

This is especially relevant in economies with low productivity and high informality. When formal employment becomes too expensive, many labor relationships move toward informal or precarious arrangements.

What determines tax incidence?

Economic incidence depends on several factors:

The Encyclopaedia Britannica explains tax incidence as the analysis of who finally bears the burden of a tax. As additional support, the Tax Foundation summarizes how that burden may fall on workers, consumers, owners or investors, not only on the person who legally remits the tax.

Economic effects of taxes

The most visible effect of a tax is revenue. The state receives money.

But economic analysis does not end there.

Taxes also change incentives, relative prices, investment decisions, formality, saving, hiring and consumption.

Lower disposable income

When a person pays taxes on wages or income, that person has less money available to decide independently.

He or she may save less, consume less, invest less, help family members less or depend more on state services.

Example: two gross salaries may look identical, but the net salary depends on taxes, contributions and deductions. For daily life, net salary is what actually allows a person to pay for food, transport, housing, education, health care or saving.

Higher prices

Consumption taxes, tariffs and burdens on businesses can appear in prices.

This does not always happen fully or immediately. It depends on the market. But the possibility exists and is central.

A tax does not disappear because it is charged “to the company.” It can appear in the product’s price, lower quality, less variety, less investment or lower availability.

Less saving and investment

Taxes on income, profits, dividends, capital gains or wealth can reduce the expected return from saving and investing.

If investment becomes less profitable or more uncertain, some people consume sooner, move capital, reduce projects or avoid formalizing activities.

This matters because investment is not a luxury for the rich. It is what allows better tools, better processes, higher productivity, better wages and greater future productive capacity.

Lower incentive to work, produce or hire

Taxes alter the marginal reward for producing more.

If every additional hour of work, every extra sale or every successful investment is taxed at a very high burden, behavior may change. Some people work less, declare less, refuse to grow, divide operations, move into informality or seek more complex legal structures.

This does not mean that every tax destroys work. It means that incentives matter.

Compliance costs

The cost of a tax is not only the amount paid.

Compliance also costs money and time.

A taxpayer may need:

For a large company, those costs may be absorbable. For a small entrepreneur, they may be decisive.

The International Monetary Fund treats tax policy as a problem of institutional design, efficiency, equity and administration, not only as a question of collecting more. That perspective helps explain why complexity also matters.

Deadweight loss

A tax can prevent exchanges that would have benefited both parties.

Example: a buyer was willing to pay 100 and a seller was willing to sell at 95. The exchange was possible. But if a tax raises the final price or reduces the seller’s net income, the transaction may not occur.

Revenue is money transferred to the state. The activity that never happened is a lost opportunity.

That is called deadweight loss: economic value that remains with neither the consumer, nor the producer, nor the state.

Taxes and informality

Informality does not have a single cause. It may reflect low productivity, weak institutions, corruption, legal insecurity, lack of credit, bureaucracy, excessive regulation, distrust and a culture of noncompliance.

The World Bank has studied informality as a persistent reality that affects productivity, social protection, access to finance and state capacity. Within that broader picture, the fiscal and administrative burden can be a relevant factor.

A small entrepreneur may ask:

If formality imposes costs above the entrepreneur’s real capacity, the incentive to remain informal increases.

This is not a defense of tax evasion. It is an analysis of incentives.

Informality reduces legal protection, access to credit, productivity, revenue and labor stability. But fighting it only with more coercion can fail if the formal system remains too costly, arbitrary or unreliable.

The liberal point is this: a simpler, more general, more predictable and less onerous system may encourage compliance better than a complex system that pushes small actors outside legality. This is not an automatic guarantee; it is an institutional criterion for reducing incentives to noncompliance.

Taxes, private property and state power

Private property does not mean only “having things.” It means being able to use, manage, exchange, save, invest, donate or transfer legitimately acquired resources.

Taxes limit that control.

Taxing income limits control over the fruit of one’s work.

Taxing consumption limits purchasing power.

Taxing wealth limits asset accumulation.

Taxing inheritances limits the family transmission of property.

Taxing imports limits the freedom to trade with people in other countries.

This does not prove by itself that every tax is illegitimate. But it does show why taxation should not be treated as a simple administrative technique.

When does a tax become confiscatory?

Confiscatory taxation describes taxes that are so high, repeated or invasive that they substantially erode property.

Its legal definition varies by country, court and context. The term should therefore be used carefully.

But the political concern is valid: if the state can tax without limits, then private property becomes conditioned by the fiscal tolerance of political power.

As a liberal warning, when there are no effective limits, property may begin to look less like a stable right and more like an authorization conditioned by future fiscal decisions.

Property, consent and the rule of law

In the liberal tradition, legitimate taxation requires more than fiscal need. It requires general rules, legal approval, political representation, certainty, constitutional limits, control of spending and respect for rights.

This concern connects with broader principles of classical liberalism: limited power, private property, individual freedom and the rule of law.

It also connects with the principles of classical liberalism, where political power is not presumed morally unlimited simply because it acts in the name of the public interest.

Taxes and economic freedom

Economic freedom is the ability to work, produce, save, invest, hire, start businesses, consume and exchange with the lowest possible degree of arbitrary coercion.

Taxes affect that freedom because they reduce the margin of private decision.

They matter not only because of how much revenue they raise. They matter because of how they condition behavior.

Less individual decision over one’s own money

Every tax replaces an individual decision with a political decision.

The individual could have saved, invested, bought, donated, hired, paid a debt or started a project. The state decides on another use.

That use may be valuable or not. But the displacement exists.

Less room to start and grow a business

An entrepreneur does not decide only whether the idea is good. The entrepreneur decides whether the project can survive taxes, fees, labor charges, procedures, inspections, registries, potential fines and regulatory changes.

A complex tax system may favor those who can pay for advisers and legal structures, while punishing those who operate with little capital.

That is why tax complexity can also concentrate markets: large firms tolerate bureaucracy better; small firms remain outside the system or stay informal.

Greater dependence on the state

When the state collects and redistributes more, it also increases its capacity to condition sectors, groups and citizens.

It can finance services, but it can also build political dependencies, reward allies, punish sectors, direct behavior and expand bureaucracies.

The liberal question is not only “which program sounds noble.” It is who decides, under what limits, under what controls and with whose resources.

Greater discretionary power

A tax system with many exemptions, special regimes, selective benefits and discretionary inspections increases bureaucratic power.

Not everyone faces the same rules. Some sectors receive privileges. Others bear the cost.

From a rule-of-law perspective, this is dangerous. Taxation should be general, clear and predictable, not a tool for negotiating favors or punishments.

The classical liberal view of taxes

Classical liberalism has not historically been a single doctrine against every tax.

Many classical liberals accepted limited taxes to finance restricted state functions: justice, security, defense, the administration of law and certain public works that were difficult to finance voluntarily in their historical context.

Adam Smith, in Book V of The Wealth of Nations, formulated classic maxims of taxation: proportionality, certainty, convenience and economy in collection.

Translated into contemporary language, a tax should be:

The classical liberal position does not simply say “zero taxes.” It says: if the state is going to collect taxes, it must do so within strict limits and with public justification.

The key point

For classical liberalism, taxation may be tolerated as a limited instrument for a limited state. But fiscal necessity does not grant unlimited permission to expand state power.

A tax is more compatible with liberty when it is general, transparent, legally predictable, difficult to manipulate for political favors and tied to functions that can be publicly justified.

The more radical libertarian critique

The libertarian critique goes further.

For many libertarians, taxation is not merely a tool that can be badly designed. It is structurally coercive because it takes resources from individuals without their explicit consent. In that view, the problem is not only excess taxation, but the compulsory nature of taxation itself.

Murray Rothbard developed one of the most radical critiques of taxation and state intervention in Power and Market. That position should be understood as a normative argument about property, consent and coercion, not as a neutral institutional consensus.

From this perspective, the fact that a democratic majority approves a tax does not automatically solve the moral problem. If individual property is a real right, then majority approval does not make every transfer legitimate.

The classical liberal and libertarian positions can therefore be distinguished as follows:

What about public goods and institutional financing?

A serious critique of taxes cannot ignore the strongest objection: some institutional functions need financing.

Justice, security, defense, basic administration of law and certain infrastructure problems have historically been cited as reasons to collect taxes. A society without rules, courts or security can also threaten property and freedom.

The liberal response is not to pretend that institutional financing is irrelevant. The response is to ask harder questions:

This is where the idea associated with Frédéric Bastiat matters. In Selected Essays on Political Economy, Bastiat emphasized the need to look not only at what is seen, but also at what is not seen. Applied to taxes, the visible side is the public program financed. The less visible side is the private consumption, saving, investment, hiring and entrepreneurship that did not occur because the resources were taken first.

How to evaluate a tax system from a liberal perspective

A tax system can be judged by more than how much it collects.

From a liberal perspective, the relevant questions include whether the system is clear, general, limited, predictable and compatible with private property and economic freedom.

Legal clarity

The taxpayer should be able to understand the obligation. A system that only specialists can interpret gives excessive power to bureaucracy and tax advisers.

Generality

The rules should apply generally, not through a jungle of privileges, exemptions and special regimes created for favored groups.

Low arbitrariness

A tax system should not depend on the discretionary mood of officials. Inspection, sanction and interpretation powers must be limited by law and reviewable by independent institutions.

Low economic distortion

No tax is completely neutral. But some taxes distort production, saving, hiring, trade or investment more severely than others. A prudent system should minimize damage to productive activity.

Transparency in spending

Collecting more is not a virtue if spending is opaque, clientelist, inefficient or captured by political interests. The taxpayer has a legitimate interest in knowing how resources are used.

Constitutional and political limits

Fiscal power should not be open-ended. A free society needs limits on taxation, borrowing, inflationary financing and the administrative power used to enforce fiscal policy.

Common objections about taxes

“Without taxes, there would be no state”

This objection has force if one assumes that certain state functions are necessary. But it does not settle the real debate.

The central issue is not whether the state needs resources. It is how much it needs, for what functions, under what limits, with what transparency and at what cost to private freedom.

“The rich should pay more”

Progressive taxation is usually defended through ability to pay and redistribution. The liberal critique should not caricature that argument.

The issue is that very high or poorly designed taxes can reduce investment, encourage avoidance, punish capital accumulation, generate political targeting and expand bureaucratic discretion. A progressive tax may sound fair in the abstract, but it must still be evaluated by its incentives, administrative costs, legal certainty and respect for property.

“Taxes redistribute wealth”

Taxes can redistribute resources. The question is whether the redistribution is just, efficient, transparent and compatible with individual rights.

Redistribution can become dependence, clientelism or political control if the state uses resources to reward loyal groups, punish dissenting sectors or maintain permanent electoral machines.

“Taxes are the price of civilization”

This phrase is common, but incomplete.

A society needs order, law and institutions. But a tax is not a market price. A price is paid voluntarily in exchange for a good or service. A tax is imposed by law and backed by coercion. The fact that some public functions are valuable does not erase the need for limits, accountability and justification.

Conclusion

Taxes are mandatory transfers of resources from individuals and businesses to the state. They finance public spending, but they also change incentives, prices, wages, investment, formality, entrepreneurship and the real scope of private decision-making.

Their legal form does not always reveal their economic burden. A tax legally charged to a company may be partly borne by consumers, workers, investors or suppliers. A tax justified as redistribution may produce bureaucracy, dependency or lower investment. A tax described as technical may expand political power over property and economic life.

From a liberal-libertarian perspective, understanding taxes means understanding the power of the state. The issue is not only how much the government collects, but what it prevents, whom it burdens, what incentives it creates and what limits restrain it.

A freer society does not treat taxation as a blank check. It demands clarity, general rules, transparency, legal certainty, lower arbitrariness, fiscal discipline and respect for private property. If the state claims the power to take part of what people earn, consume, save or transfer, that power must always be justified, limited and watched.

Frequently asked questions about taxes

What are taxes in simple terms?

Taxes are mandatory payments that the state requires by law from individuals or businesses. They are not voluntary purchases; they are obligations backed by legal coercion.

What is the difference between a tax and a fee?

A tax is collected without a direct individualized service in return. A fee is linked to a specific administrative service, license, procedure or regulated use.

What are taxes used for?

States use taxes to finance public spending, redistribute resources, modify behavior and sustain public institutions and bureaucracies.

What types of taxes exist?

The most common types include income taxes, consumption taxes, wealth taxes, inheritance taxes, corporate taxes, tariffs and excise taxes on specific products or activities.

What is the difference between direct and indirect taxes?

Direct taxes apply to income, profits or wealth. Indirect taxes apply to consumption, transactions, imports or the circulation of goods and services.

Who really pays taxes?

The person who legally pays or remits a tax is not always the person who bears its final economic cost. The burden may shift to consumers, workers, shareholders, suppliers or clients through prices, wages, margins and investment decisions.

Why do taxes affect prices?

Taxes can raise production, import, labor or transaction costs. Depending on market conditions, part of those costs can be reflected in higher prices, lower quality, less variety or lower investment.

How do taxes affect workers?

Taxes affect workers through lower net income, higher consumer prices and, in some cases, lower future wages or less formal employment when hiring becomes more expensive.

How do taxes affect businesses?

Taxes can reduce profitability, raise compliance costs, discourage investment, affect hiring decisions and make formal operation more expensive, especially for small businesses.

Do taxes reduce economic freedom?

Yes, in the sense that every tax reduces the portion of income, consumption, wealth or transactions that individuals can decide over directly. The extent of the impact depends on the tax level, design, enforcement and use of the funds.

What does classical liberalism say about taxes?

Classical liberalism has generally accepted limited taxation for limited state functions, but it demands clear rules, legal certainty, generality, accountability and strict limits on fiscal power.

What does libertarianism say about taxes?

Libertarianism tends to criticize taxation more radically as coercion over private property. Some libertarians reject the legitimacy of taxation itself, not only excessive taxation.

Can a state exist without taxes?

A modern state normally uses taxes to finance itself. The liberal debate is not only whether some financing is needed, but how much, for what purposes, under what limits and with what alternatives.

When can a tax be considered confiscatory?

A tax may be considered confiscatory when it is so high, repeated or invasive that it substantially erodes property. The legal definition varies by country and court, so the term should be used carefully.