Nonetheless, it makes sense to consider which policy approaches might reach these objectives at the lowest economic cost to each country. To understand why requires a look at how these policies may interact with taxes that already exist in the economy. The Tax-Interaction Effect Government spending in the United States is financed primarily by taxes on labor and capital income. That is, they reduce employment and investment below levels that would maximize economic efficiency. For example, because personal income taxes reduce take-home pay, the partner of a working spouse may be discouraged from joining the labor force, an older worker may retire earlier, or a worker with one job may be discouraged from working additional hours in a second job.
Employers are likely to hire less labor if social security taxes make employees more expensive.
Similarly, capital gains and corporate income taxes reduce the incentives for individuals to save and for firms to invest in new production capacity. Environmental taxes and regulations tend to discourage economic activity because they raise the costs to firms of producing output. Typically, this leads to a lower overall level of employment and investment in the economy. The resulting economic cost has been termed the tax-interaction effect. The new tax would increase the costs to firms of purchasing coal and oil in particular, which in turn would increase the cost of electricity and gasoline.