4.5 Flashcards
What are direct taxes?
- Direct taxation is levied on income, wealth and profit
- Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax (a tax on business profits)
- The burden of a direct tax cannot be passed on to someone else
What is indirect taxation?
- Indirect taxes are usually taxes on spending
- Examples of indirect taxes include excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services together with the sugar tax
- Producers may be able to pass on an indirect tax – depending on price elasticity of demand and supply.
What are progressive taxes?
- With a progressive tax, the marginal rate of tax (MRT) rises as income rises.
- As people earn more, the rate of tax on each extra pound goes up. This increases the average rate of tax.
- Income tax in the UK is a progressive tax:
- Income tax on earned income is charged at three rates: the basic rate, the higher rate and the additional rate.
- For 2019-20 these rates are 20%, 40% and 45% respectively.
What are regressive taxes?
- With a regressive tax, the rate of tax paid falls as incomes rise – I.e. the average rate of tax is lower for people on higher incomes. Examples include: Duties on tobacco and alcohol.
- A tax is said to be regressive when low income earners pay a higher proportion or percentage of their income in tax than high income earners.
What is the Laffer curve?
- It is a (supposed) relationship between economic activity and the rate of taxation which suggests there is an optimum tax rate which maximises total tax revenue
- Why might total tax revenues fall if the tax rate increases?
o Increased rates of tax avoidance – greater incentive to seek out tax relief, make max use of tax
allowances
o Greater incentive to evade taxes (illegal) – i.e. non–declaration of income and wealth
o Possible disincentive effects in the labour market – depending on which taxes have been increased
o Possible “brain drain” effects – including the loss of highly skilled and high-income taxpayers
What are some evaluations of the Laffer curve concept?
- Lower top rate taxes might increase income inequality
- Little evidence that high top rates of income tax is a barrier to inward migration of skilled labour
- Many people are on fixed hours / Zero Hour contracts – so tax rates may have little bearing on work incentives
- For some people, tax cuts will cause them to take more leisure time instead of work – a backward bending labour supply curve effect – especially at higher wages/ earnings
- There is a Keynesian explanation for some aspects of the Laffer Curve – cuts in direct and indirect taxes increase real disposable income and therefore lead to higher consumer spending and aggregate demand
How do changes in taxation affect AD?
- Changes in tax rates and tax allowances have direct and indirect effects on the level/growth of AD
- Changes in income tax and national insurance have a direct effect on people’s disposable incomes
- Changes in corporation tax affect the post-tax profit available for businesses to invest
- Changes in employers’ national insurance affect the cost of employing extra workers in the labour market
- A change in value added tax brings about changes in retail prices and affects the real incomes of consumers
How does taxation affect AS?
- Changes in tax rates and tax allowances have a direct and indirect effect on SRAS and LRAS
- Changes in VAT affect business costs e.g. the VAT applied when buying component parts / supplies
- Changes in direct taxes can influence work incentives
- Changes in business taxes might affect the level of foreign direct investment into a country
- Taxes can also affect the incentive to start a business or to spend money on research and development
Explain a chain of reasoning and evaluate the impact of cuts in corporation tax.
- The government cuts the rate of corporation tax
- Businesses get to keep a larger percentage of their operating profits.
- Increase in post-tax profitability may lead to a rise in planned investment
- Investment can be by both domestic and overseas businesses
- Increased capital spending is an injection into the circular flow model
- Creates a positive multiplier effect on demand, output and employment.
EV - Impact depends on the scale of tax cut and whether it is long-lasting or considered to be a temporary measure.
- Many factors affect capital investment e.g. the pace of technological changes and strength of market competition.
- Some extra investment may lead to loss of jobs through capital-labour substitution effects
Analyse the possible impacts of a rise in the standard rate of VAT.
Inflation; Higher in SR as businesses pass on tax
Economic growth; slower as real incomes and demand falls.
Unemployment; higher if AD weakens
Balance in trade of goods and services; Improved- falling incomes may cause demand for imports to contract
Spare capacity in the economy; rising spare capacity from weaker demand
Business investment; decline if businesses are hit by lower profits and weaker consumer spending
Government fiscal balance; Short run improvement from higher taxes but risk of falling revenues in medium term.
What are discretionary fiscal changes?
Deliberate changes in direct and indirect taxation and gov. spending- e.g. extra capital spending on roads
What are automatic stabilisers?
- Changes in tax revenues and gov. spending that comes about automatically as an economy moves through the business cycle.
Explain how automatic stabilisers work in regards to tax revs, welfare spending and budget balance/circular flow.
- Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending
- Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits
- Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit During a recession, revenue is likely to be lower due to less income earned, less profits made and fewer goods being bought and at the same time government expenditure on transfer payments e.g. income support and unemployment benefit
Explain the concept of gov. bonds
When a government borrows it issues debt in the form of bonds. The yield on a bond is the interest rate paid on state borrowing. Purchasers of British government bonds for example include pension funds, insurance companies and overseas investors. The percentage yield on sovereign (government) debt has been low in recent years for countries such as the UK and Germany but higher for nations such as Greece which has had several emergency bail-outs in recent times.
What is government borrowing?
Public sector borrowing is the amount the government must borrow each year to finance their spending.
What is national debt?
Public sector debt is a measure of the accumulated national debt owed by the gov. sector
What is public sector debt
Debt owed by central and local gov. and also state-owned corporations.
What is the difference between structural and cyclical deficits?
- During an economic boom, when real GDP is expanding, and the economy is operating above its potential (i.e. there is a positive output gap), then tax receipts are relatively high and spending on unemployment benefit is low. This reduces the level of government borrowing
- The reverse happens in a recession when borrowing tends to be high. This is because a recession leads to
rising unemployment and falling real incomes which leads to an increase in state spending on welfare assistance - The structural fiscal deficit is that part of the deficit that is not related to the state of the economy. This part of the deficit will not disappear when the economy recovers from a recession. It thus gives a better guide to the underlying level of the deficit than the headline figure. The structural deficit cannot be directly measured so it has to be estimated.
What cyclical factors impact the size of fiscal deficits?
o Rate of unemployment – higher unemployment reduces tax revenues
o Consumer spending – strong consumer spending increases VAT revenue
o Business profits – rising business profits increases revenue from corporation tax
o Automatic stabilisers – in an economic downturn, the fiscal deficit rises as G increases and T falls
What long run factors influence the size of fiscal deficits?
o Size of the welfare state – e.g. the scale and breadth of welfare assistance available
o Relative level of welfare benefits e.g. compared to incomes
o Demographic factors e.g. ageing population, the impact of net inward migration of labour
o Size of the tax base and tax rates – i.e. is an economy moving towards a lower or higher tax burden
o Efficiency of the public sector - e.g. the productivity of workers in the NHS and education in delivering services
What factors influence the size of national debt?
Scale of government spending;
* Current spending on public services
* Investment spending e.g. on infrastructure
* Spending on providing social welfare
Level of tax revenues;
* Size of the tax base e.g. how many in work and their incomes
* Efficiency of tax collection, scale of tax avoidance & evasion
Cost of servicing debt + state bail-outs;
* Yield on new and existing government bonds
* Willingness of lenders to give the government new credit
* Government rescue of businesses can add to public sector debt
What are the arguments that support the fact that rising national debt causes economic problems?
- High fiscal deficits cause rising debt interest payments
- This interest burden has an opportunity cost for less interest on debt could free up extra spending on health and education. In 2018/19, gross debt interest payments for the UK are forecast to be £53 billion
- An increase in the national debt is likely to cause higher taxes in the future. This will cut the disposable incomes of tax payers and reduce growth in the private sector
- It might be unfair if the rising tax burden falls more heavily on future generations of tax payers rather than people who benefit from government spending now.
What arguments can be used to support government borrowing?
- A rise in borrowing to fund extra government spending can have powerful effects on AD, output and employment when an economy is operating below full capacity output
- There is an automatic rise in the budget deficit to cushion the fall in AD caused by an external economic shock. A higher fiscal deficit is needed to lift AD back towards pre-recession levels and support an economic recovery
- If a fiscal stimulus works, then the budget deficit will improve as a result of higher tax revenues and reductions in welfare spending. A growing economy helps to shrink debt as a percentage of GDP
- It makes sense for a government to borrow money if interest rates are low and if the deficit is being used for investment to improve a nation’s infrastructure to aid competitiveness. Borrowing to invest can bring about much needed improvements in public services such as education, health, transport and social housing. It can lead to an increase in long run aggregate supply and therefore support long-run economic growth
What is the relationship between IRs on a bond and the yield and the market price of a bond?
Annual interest rates are FIXED!!!!
* When bond prices are rising, the yield will fall
* When bond prices are falling, the yield will rise
What is fiscal austerity?
the term used to describe policies designed to reduce the size of a government fiscal deficit and
eventually control/ lower the size of the outstanding national debt.
What are the main ways in which a fiscal deficit can be reduced?
- Cuts in gov spending
- Higher taxes
- Supply-side policies to encourage growth
How can cuts in gov spending be used to help reduce the fiscal deficit?
- Controlling public sector pay including wage freezes or limiting annual pay awards to 1%
- Limiting welfare entitlement
- Privatisation of state assets so that a government no longer has to cover losses
- Reductions in the size and scale of government subsidies
How can higher taxes be used to help reduce the fiscal deficit?
- Higher indirect taxes such as VAT rising to 20%
- Cutting tax allowances or ending certain tax reliefs
- Bringing in new taxes e.g. new environmental taxes or taxes on digital businesses
How can supply side policies to encourage growth be used to reduce a fiscal deficit?
- This approach focuses on the argument that a growing and a more competitive economy will be a more effective way of cutting the deficit and the debt in the long-term
- Stronger GDP growth increases tax revenues because the tax base widens, and people/businesses are earning higher incomes and profits
- In a progressive tax system, expanding incomes and perhaps higher prices will lead to a faster growth of tax receipt
- Growth cuts a deficit as a % of GDP because the denominator (GDP) has increased
What are the arguments in favour of fiscal austerity?
- Reducing the budget deficit and the national debt is in the long run interests of economy – for example it helps to keep UK taxes lower and can avoid the problem of the state sector crowding-out investment and growth in the private sector
- Shrinking state encourages private sector growth in the long-run
- There is a high opportunity cost from over £50 billion spent each year on debt interest
- Cutting the fiscal deficit can improve investor confidence and might attract more FDI into the UK
- The upturn of the economic cycle is time for government to borrow less – ahead of another downturn or recession – it makes sense to be running stronger budget finances before the economy enters a cyclical slowdown or downturn
What are the arguments against fiscal austerity?
- Austerity is self-defeating especially if it leads to price deflation and lower employment, because this depresses employment and investment which are vital to sustain tax revenues in the future
- Government bond yields are low – the yield on ten-year government bonds is less than 2 per cent – so this is an opportune a time to invest more because infrastructure investment will increase both AD and LRAS
- Wrong to cut state spending when economy is in a liquidity trap (i.e. unresponsive to low interest rates)
- Economic growth is needed to pay back the debt and fiscal austerity makes this harder to achieve
- There are damaging social consequences from fiscal austerity – it risks increasing inequalities of income and can be a factor in more families having to use food banks and borrowing at very high interest rates from payday lenders
- Pay freezes in the public sector have harmed recruitment and led to growing shortages of key workers in education and healthcare. This leads to longer waiting times and threatens the delivery of important merit goods.
Give examples of polices that are designed to reduce inequality of income and wealth.
- Welfare systems
- Direct cash transfers to poorer households – conditional cash transfers link cash benefits to households dependent on certain actions e.g. having their children immunised or attending school regularly
- Measures to introduce a basic pensions system – which in theory would allow households to save more of their disposable income or increase spending on necessities such as education or better health care
- Government subsidies for transport and child care to increase labour market participation
- Labour market policies
- Employment protection including legal protections for workers wanting to be represented by a trade union
- Minimum wage laws - offering a guaranteed pay floor for lower-paid workers
- Trials to introduce a universal basic income
- Incentives to improve business training / productivity which ultimately will increase productivity. Productivity is the biggest single driver of improved wages over time
- Tax reforms
- Progressive taxes on the income / wealth of the rich
- Taxing profits of businesses to fund state spending including measures to curb tax avoidance by transnational corporations
What policies can be used to improve competitiveness?
- Improving the functioning of labour markets
- Critical infrastructure investment
- Supporting enterprise and entrepreneurship
- Macroeconomic stability.
How can improving the functioning of labour markets improve competitiveness?
o Investment in all levels of education and training including early years education and technical/vocational courses for school and college leavers
o Encouraging inward migration of skilled workers – some nations have chosen a points-based system of immigration targeting skilled occupations where there are labour shortages
o Improvements in management quality
How can core infrastructure investment improve competitiveness?
o Better motorways, ports, hi-speed rail, new sewers – infrastructure gaps can severely hamper businesses
o Investment in clean energy networks to help support sustainable growth
o Communications e.g. super-fast broadband, 4G and 5G networks
How can supporting enterprise/ entrepreneurship improve competitiveness?
o Improved access to business finance e.g. for start-ups and small & medium-sized enterprises
o Incentives for business innovation and invention including lower taxation on profits from patented products
o Reductions in business red tape
How can macroeconomic stability be used to improve competitiveness?
o Maintaining low inflation / price stability to help confidence
o A sustainable and more competitive banking system to improve the flow of finance for investment
o A competitive exchange rate versus major trading partners – for some countries this has involved moving towards managed floating exchange rates and/or a competitive devaluation of a fixed exchange rate
What are external shocks?
Shocks are unexpected changes in the economy that can affect variables such as inflation and the growth rate of GDP. In an inter-connected global economy, events in one part of the world can quickly affect many other countries. For example, the global financial crisis (GFC) brought about recession in many countries and financial distress in many regions. It also led to a fall in FDI flows into poorer countries and increased pressure on governments in rich nations to cut overseas aid budgets.
What are demand side shocks?
- Economic downturn / recession in a major trading partner
- Unexpected tax increases or cuts to government spending programmes
- Financial crisis causing bank lending /credit to fall and which spreads to more than one country/region
- Unexpected changes in monetary policy interest rates
- Significant job losses announced in a major industry
What are supply side shocks?
- Steep rise/fall in oil and gas prices or other commodities traded in the world economy
- Political turmoil / strikes
- Natural disasters causing a sharp fall in production and damage to infrastructure
- Unexpected breakthroughs in production technologies which can lead to unexpected gains in productivity
- Significant changes in levels of labour migration into/out of a country
What are the macroeconomic objectives? What should you consider the impact of an external shock on?
- Real GDP growth
- Inflation (demand-pull and cost-push)
- Unemployment
- Competitiveness
- The Trade Balance
- Government finances
- Possible impact on inequality
Give examples of what factors impact how well a country can absorb economic shocks.
- Floating exchange rates (i.e. is there scope for a depreciation?)
- Freedom to set / adjust monetary policy when conditions change - does the central bank have autonomy to change interest rates or bring in unconventional policies such as QE?
- Geographically and occupationally mobile / flexible labour force - a more flexible labour force helps an economy adjust to shocks that change the pattern of exports
- Strong non-price competitiveness of domestic businesses - this helps make demand and output more resilient to fluctuations in the global economy
- A diversified economy that is not over reliant on a few sectors
- Strong fiscal position (stabilisation funds) - e.g. strong finances give a government the scope to run a fiscal stimulus when aggregate demand falls
What strategies can be used to reduce corporate tax avoidance?
- Some governments want to introduce a standard minimum tax rate on corporate profits across all of the advanced countries.
- Others favour introducing new digital services taxes specifically for businesses such as Amazon, Apple, Facebook and Google.
What is transfer pricing?
Transfer pricing is also known as profit shifting and it happens when a TNC moves the profits they have made from subsidiaries in a high tax country to other subsidiaries in a lower tax nation. Usually this happens when a TNC sets up an internal trade - for example a royalty for using a trademark or a charge for using component parts which then affects the costs of each subsidy and helps to ensure that lower profits are booked in the higher-tax economy
What are the potential benefits of TNCs for host countries?
- Provision of significant employment and training to the labour force in the host country
- Transfer of skills and expertise, helping to develop the quality of the host labour force
- TNCs add to the host country GDP through their spending, for example with local suppliers and through capital investment
- Competition from MNCs acts as an incentive to domestic firms in the host country to improve their competitiveness, perhaps by raising quality and/or efficiency
- TNCs extend consumer and business choice in the host country
- Profitable MNCs are a source of significant tax revenues for the host economy (for example on profits earned as well as payroll and sales-related taxes)
What are potential drawback of TNCs on host countries?
- Domestic businesses may not be able to compete with MNCs and some will fail
- TNCs may not feel that they need to meet the host country expectations for acting ethically and/or in a socially-responsible way
- TNCs may be accused of imposing their culture on the host country, perhaps at the expense of the richness of local culture.
- Profits earned by TNCs may be remitted back to the TNC’s base country or low tax haven rather than reinvested in the host economy.
- TNCs may make use of transfer pricing and other tax avoidance measures to significantly reduce the profits on which they pay tax to the government in the host country.
