4.5 - Role of the state in the macroeconomy content Flashcards
What are some examples of current spending
- Salaries of NHS employees
- Drugs used in health care
- Road maintenance budget
- Army logistics supplies
What are some examples of capital spending
- Construction of new motorways and bridges
- New equipment in the NHS
- Flood defence schemes
- Extra defence equipment
Why is government spending significant
- Government spending is a key component of aggregate demand and LRAS
- State spending can have a regional economic impact e.g. from spending on regional infrastructure projects.
- Important in providing public & merit goods to the wider population.
- Can help to achieve greater equity in society.
How can government spending affect household incomes
- Welfare Transfers: Direct payments such as universal child benefits, unemployment benefits, public pensions, and targeted welfare boost disposable incomes.
- State-Provided Services: Public provision of education, healthcare, social housing, and employment training reduces household costs and promotes income equality.
Help with equity
What are the Justifications for Government Spending?
- Market Failures: Provide merit/public goods (education, healthcare) to counteract private sector undersupply and build human capital.
- Social Equity: Implement welfare and redistributive policies to cut poverty and ensure fair income distribution.
- Infrastructure Investment: Fund core projects that lower production costs and boost long-run productivity and growth.
- Macroeconomic Stability: Use fiscal measures to balance aggregate demand, reducing unemployment and inflation.
- Enhancing Competitiveness: Support innovation and skills training to improve efficiency and secure lasting returns.
What is the free market agenda thoughts on the size of the government
- Limited Impact of Spending: Free market economists doubt that government spending significantly improves supply-side performance.
- Lower Taxes & Spending Control: They advocate for lower taxation and strict control over government spending/borrowing (crowding-out theory) to let the private sector thrive.
- Smaller State Preference: A reduced state role helps lower the overall tax burden, promoting long-run private sector growth.
What are the problems with government expenditure?
- High levels of taxation required - this has a disincentive effect.
- Crowding out - Creates competition for resources, pushing up costs.
- Low productivity and growth - because state sector is not motivated by profit so little incentive to increase efficiency.
- Increase in national debt - increased interst payments, less public expenditure for schools and hospitals.
What are the two types of crowding out?
- Resource crowding out - more competition for factors of production increases prices.
- Financial crowding out - higher demand for loanable funds increases interest rates
More difficult for the private sector = more inefficient economy.
What is crowding out
A rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower. It can lead to higher taxes and interest rates which then squeezes profits, investment and employment in the private sector.
What does a crowding out diagram look like when there is more government borrowing
Increased government borrowing may lead to higher demand for loanable funds and therefore a rise in market interest rates e.g. on bonds. This might then increase borrowing costs for private sector businesses
What are some evaluations of crowding out
- Rare crowding-out: Unlikely when economies have unused capacity and enough savings to finance state borrowing without displacing private sector activity.
- Crowding-in effect: Fiscal deficits often stimulate demand and encourage private investment during economic downturns by boosting confidence.
- Multiplier effect: Well-targeted government spending utilizes idle resources, driving economic growth, job creation, and generating extra tax revenue.
- External funds: Crowding-out theory assumes limited domestic funds, but access to international financing challenges this limitation.
How can crowding in occur when there is inflation?
Inflation characterised by high interest rates. Govt. spending G. will lessen real interest rates (Loanable funds theory).
(Encouraging private sector investment).
(Inflation also reduces the real value of interest rates).
How do we evaluate the ‘crowding in’ effect during times of deflation?
his is only useful if interest rates are low and ‘sticky’ i.e. liquidity trap.
(During times of deflation, real interest rates are increase, due to fisher equation: real i = nominal i - inflation).
What is crowding-in?
When an increase in government spending/investment leads to an expansion of economic activity (real GDP) which in turn incentivizes private sector businesses to raise their own levels of capital investment and employment. Crowding-in is a view supported by Keynesian economists.
What are the micro impacts of fiscal austerity
- Output, jobs and profits in construction, transport & defence sectors.
- Effects on real income and relative poverty of households.
- Effective demand for goods and services e.g. welfare caps might change the pattern of demand for goods and services.
- Cuts in pension spending might lead some people to delay their retirement.
What are the macro impacts of fiscal austerity
- Negative multiplier effects of cuts in public sector spending and employment.
- Lower fiscal deficit might help investor confidence / attract investment.
- Risks of deflationary pressures if cutting spending creates excess capacity (negative output gap).
- Bank of England more likely to keep interest rates at very low levels
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 are indirect taxes
- 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
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 a proportional tax?
Different income levels pay the same % in tax.
(E.g. National Insurance contributions).
What does the Laffer curve show?
A rise in tax does not necessarily increase tax revenue.
There is an optimum level, deviating from it will result in lower tax revenue.
Why might total tax revenues fall if the tax rate increases
- Increased rates of tax avoidance – higher taxes create a greater incentive to seek out tax relief, make max use of tax allowances.
- Greater incentive to evade taxes (which is illegal) – i.e. non–declaration of income and wealth.
- Possible disincentive effects in the labour market – depending on which taxes have been increased. disincentives to work
- Possible “brain drain” effects – including the loss of highly skilled and high-income taxpayers. occured in Norway
Where is the T*on the Laffer curve?
Impossible to tell. The Laffer curve is not nuanced or specific enough.
Joseph Stiglitz argued that the optimum tax rate is around 70%.
Some have said it is around 30%
Why might high income taxes not disincentivise work?
- Nordic countries have high taxes and welfare benefits, but have simiar rates of growth compared to lower tax economies like the UK and US
- Higher taxes might mean that people have to work longer hours to maintain their income and living standards so might even increase incentives to work
What are some evaluations of the Laffer Curve
- 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 impact on work incentives.
- Are we actually more motivated to work if income tax falls? For some people, tax cuts will cause them to take more leisure time instead of work – leading to 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 does taxation affect aggregate demand
- 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 aggregate supply
- 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 affect the incentive to start a business or to spend money on research and development.
What is a chain of reasoning for the impact of a cut in corporation tax (positve)
- 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
How can the positve impacts of a cut in corporation tax be evaluated
- Impact depends on the scale of the 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 change and strength of market competition.
- Some extra investment may lead to a loss of jobs through capital-labour substitution effects.
How is inflation affected by a rise in VAT from 20% to 25%
Higher in short run as businesses pass on tax
How is Economic Growth affected by a rise in VAT from 20% to 25%
Slower as real incomes and demand falls
How is Unemployment affected by a rise in VAT from 20% to 25%
Higher if aggregate demand weakens
How is the balance of trade in goods and services affected by a rise in VAT from 20% to 25%
Improved – falling incomes may cause demand for imports to contract
How is spare capacity in the economy affected by a rise in VAT from 20% to 25%
Rising spare capacity from weaker demand
How is business investment affected by a rise in VAT from 20% to 25%
Decline if businesses are hit by lower profits and weaker consumer spending
How is government fiscal (budget) balance affected by a rise in VAT from 20% to 25%
Short run improvement from higher taxes but risk of falling revenues in medium term
laffer curve
What are discretionary fiscal policy
Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for example, extra capital spending on roads or more resources into the NHS.
What are automatic stabilisers
Automatic stabilisers are changes in tax revenues and government spending that come about automatically as an economy moves through the business cycle
What is the explanation for automatic stabilisers
- 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: In a fast-growing economy, money tends to flow out of the circular flow. During a recession, lower revenues from reduced income, profits, and consumption, combined with increased government spending on transfer payments like unemployment benefits, typically result in larger budget deficits.
What is government borrowing
Public sector borrowing is the amount the government must borrow each year to finance their spending.
What is public sector debt
Public sector debt is owed by central and local government and by state-owned corporations.
What is national debt
Public sector debt is a measure of the accumulated national debt owed by the government sector.
How many surpluses have there been in the UK since 1970/71
Only 6 surplus years since 1970/71 so 49 out of the last 55 years has been deficit
Distinction Between Structural and Cyclical Deficit
- Cyclical Deficit:
- Varies with the state of the economy
- During an economic boom (above potential, positive output gap):
- High tax receipts
- Low spending on unemployment benefits
- Reduced government borrowing
- During a recession:
- Lower incomes, profits, and consumption
- Increased spending on welfare and unemployment benefits
- Higher government borrowing
- Structural Deficit:
- Represents the part of the fiscal deficit not influenced by the business cycle.
- Persists even when the economy is at full potential.
- Provides a clearer picture of the underlying fiscal imbalance but must be estimated as it cannot be directly measured.
What are the Cyclical factors influencing the size of fiscal deficits
- Rate of unemployment – higher unemployment reduces tax revenues.
- Consumer spending – strong consumer spending increases VAT revenue.
- Business profits – rising business profits increases revenue from corporation tax.
- Automatic stabilisers – in an economic downturn, the fiscal deficit rises as G increases and T falls.
What are the long run factors influencing the size of fiscal deficits
- Size of the welfare state – e.g. the scale and breadth of welfare assistance available.
- Relative level of welfare benefits e.g. compared to incomes.
- Demographic factors e.g. ageing population, the impact of net inward migration of labour.
- Size of the tax base and tax rates – i.e. is an economy moving towards a lower or higher tax burden.
- Efficiency of the public sector - e.g. the productivity of workers in the NHS and education in delivering services.
What are the factors influencing the size of national debts
- Scale of government spending
- Current spending on public services such as education and health care
- Investment spending e.g. on infrastructure in sectors such as transport, health, education & environment
- Spending on providing social welfare including universal credit and the state pension
- Level of tax revenues
- Size of the tax base e.g. how many people in work and their incomes. How many businesses are profitable?
- Efficiency of tax collection, scale of tax avoidance & evasion.
- Cost of servicing debt + state bailouts
- 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.
Arguments that rising national debt creates 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 were 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 taxpayers and reduce growth in the private sector
- It might be unfair if the rising tax burden falls more heavily on future generations of taxpayers rather than people who benefit from government spending now
Counter arguments – the case for 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 when interest rates are low and the funds are invested in infrastructure that boosts competitiveness. This borrowing improves public services—like education, health, transport, and housing—lifts long-run aggregate supply, and supports sustained economic growth.
What is Fiscal Austerity
Fiscal austerity involves policies to reduce a government’s deficit and control its national debt. The UK has pursued austerity since the Global Financial Crisis in 2010, while countries like Greece and Italy have implemented similar measures under EU and IMF bailouts.
What are 3 policies to reduce a fiscal deficit
- Cuts in government spending
- Higher taxes
- Supply-side policies to encourage growth
How do cuts in government spending reduce a 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 do higher taxes reduce a 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 do Supply-side policies to encourage growth 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, rising incomes and higher prices will lead to a faster growth of tax revenues
- Growth cuts a deficit as a % of GDP because the denominator (GDP) has increased
What are some 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
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
- There is always a shock around the corner – Ukraine, Trump
What is the Keynesian view on fiscal policy
Active use of fiscal policy – fiscal multiplier from gov spending. Can help to stabilise confidence, demand, output and jobs especially after severe external economic shocks
- Counter cyclical policies – active measures to inject extra demand can drag an economy out of a recession
- Targeted tax changes – Tax cuts for lower income groups with higher propensity to spend boosts AD
- Government capital spending – Keynesians favour labour-intensive projects such as new transport infrastructure projects and house-building
- Government borrowing can pay for itself – Depending on the size of the fiscal multiplier – borrowing will create more tax revenue
What is the fiscal mutliplier
If the fiscal multiplier is a high positive number, then a well-timed fiscal stimulus might be highly effective in helping to lift aggregate demand, production, incomes and jobs as an economy tries to recover from a deep recession / downturn.
The size of the fiscal multiplier depends on:
- How the fiscal stimulus is financed e.g. via increased borrowing
- Extent to which a stimulus leads to higher interest rates / inflation
- Degree to which an economy is open to imports (M is a leakage)
- Impact on consumer & business expectations and confidence
- Marginal propensity to consume and save of households affected
What is the argument in favour of increased infrastructure spending as a stimulus policy
Creates 000’s of jobs in construction and supply-chain industries. Impacts on both AD and LRAS
What is the drawback of increased infrastructure spending as a stimulus policy
Bigger projects may suffer delays and cost over runs
What are the arguments in favour of cutting value added tax as a stimulus policy
Reduces prices and increases real incomes for consumers. Could be used to help tourism & hospitality
What are the drawbacks of cutting value added tax as a stimulus policy
Jobs rather than prices are the main driver of spending. Cutting income tax for poorer families might be a more effective policy
What are the arguments in favour of reducing employers’ national insurance
Reduces payroll costs for firms and helps keep unemployment down
What are the drawbacks of reducing employers’ national insurance
Very expensive for the government. Targeted fiscal stimulus might be better strategy
What are 3 policies designed to reduce inequality of income and wealth
- Welfare system
- Labour market policies
- Tax reforms
How can welfare systems reduce inequality of income and wealth
- 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 childcare to increase labour market participation
- School feeding programmes in low and middle-income countries (an example of “benefits in kind)) which generally benefit the poorest children
How can labour market policies reduce inequality of income and wealth
- 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 real wages and higher per capital incomes over time.
What can tax reforms to as a policy designed to reduce inequality of income and wealth
Progressive taxes on the income and wealth of the rich.
Taxing profits of businesses to fund state spending including measures to curb tax avoidance by transnational corporations.
What is a universal basic income
A Universal Basic Income (UBI) is when all adults receive a no-strings-attached amount of money from the state to cover the basic cost of living.
With a basic UBI, the set amount is paid to everyone, regardless of their income or wealth.
Countries such as Kenya, India and Finland have been experimenting with a form of universal basic income with mixed results thus far.
Advantages of a universal basic income
- UBI would be a direct way of reducing absolute poverty & lifting personal freedom and security – reducing exposure to high interest debt and risks of needing emergency foodbank support.
- UBI seen by supporters as a progressive policy designed to reduce relative poverty – which avoids the stigma attached to many means-tested welfare benefits.
- It allows a government to cut welfare spending and reduce the complexity of the tax and welfare system to reduce disincentives.
- UBI is seen as way of getting money into the hands of the working poor and reducing poverty where the future of work seems increasingly insecure e.g. from robots and artificial intelligence.
- Creativity in the workplace might be improved as people may have greater income stability and be more inclined to take risks.
Risks and drawbacks from a universal basic income
- Affordability – would people give up their income tax allowance or would higher rate taxes rise?
- Work incentives – does a basic income diminish or enhance the incentive to search for paid work and be entrepreneurial?
- Effectiveness – the Finnish experiment found an increase in well-being but little noticeable impact on employment
- Universality – would it genuinely be a universal basic income for all, or would there be some conditions attached?
- Opportunity cost – money invested in cash transfers cannot be invested elsewhere unless public borrowing/debt rises too
- Alternatives – which works best? Cash transfers or free public services such as childcare and transport?
What are some polices that could improve international competitiveness
- Improving the functioning of labour markets
- Critical (Core) infrastructure investment
- Supporting Enterprise/Entrepreneurship
- Macroeconomic stability
How can improving the functioning of labour markets improve international competitiveness
- Investment in all levels of education and training including early years education and technical/vocational courses for school and college leavers.
- Encouraging inward migration of skilled workers – some nations have chosen a points-based system of immigration targeting skilled occupations where there are labour shortages.
- Improvements in management quality.
How can Critical (Core) infrastructure investment improve international competitivness
- Better motorways, ports, hi-speed rail, new sewers – infrastructure gaps can severely hamper businesses.
- Investment in clean energy networks to help support sustainable growth.
- Communications e.g. super-fast broadband, 4G and 5G networks.
How does supporting enterprise/entrepreneurship improve international competitiveness
- Improved access to business finance e.g. for start-ups and small & medium-sized enterprises.
- Incentives for business innovation including lower taxation on profits from patented products.
- Reductions in business red tape.
How does macroeconomic stability improve international competitiveness
- Maintaining low inflation / price stability to help confidence.
- A sustainable and more competitive banking system to improve the flow of finance for investment.
- 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 some examples of 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 some examples of 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 some policies to absorb the effects of an economic shock
- 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 is the keynesian approach to external economic shocks
- Keynesians believe that free markets are volatile and not self-correcting in the event of an external shock
- The free-market system is prone to lengthy periods of recession & depression
- Economies can remain stuck in an “underemployment” equilibrium
- In a world of stagnation or depression, direct state intervention may be essential to restore confidence and lift demand.
- Keynes was one of the first economists to criticise the economics profession for adhering to unrealistic assumptions
What is the scale of tax avoidance?
The scale of tax avoidance is significant:
- Global corporate tax losses are estimated at $100–240 billion annually, disproportionately affecting developing nations.
- In the UK, nearly £6 billion is lost each year due to multinational tax avoidance.
- US firms report more profits in low-tax countries like Ireland (effective tax rate: 5.6%) than in major economies combined.
What is transfer pricing
Transfer pricing, or profit shifting, occurs when a TNC moves profits from subsidiaries in high-tax countries to those in low-tax countries. This typically involves internal trades, such as royalties for trademarks or charges for component parts, which adjust costs and reduce reported profits in higher-tax economies.
What are the methods used by large businesses to avoid paying tax
- Reinvested revenue to achieve faster growth (Amazon is a good example) which then means less profits to be taxed
- Much of a company’s operating profit might be earned in foreign countries – they may “book” this in nations where corporate tax rates are low e.g. Ireland
- They take advantage of tax credits / rebates for research and development including investment in renewable energy projects
- They take advantage of schemes such as employee-share ownership schemes – the cost of which might be then offset against their tax liability
What are some policies to reform and reduce tax avoidance
- Diverted profit tax: Known as the “Google Tax” - the 25% rate tax will apply to a company’s profits diverted from the UK through complex arrangements.
- Stronger audit procedures: This is used in Germany which has collected over Euro 64bn in extra revenue from large multinationals over the last five years
- Criminal sanctions for TNCs and their executives: This targets people who engage in tax evasion – personal liability for shareholders & directors for missing tax
- International (multilateral) agreement on corporation tax: Some governments want to introduce a standard minimum tax rate on corporate profits across all of the advanced (OECD) countries.
- New digital services taxes: This is for businesses such as Amazon, Apple, Netflix, Facebook and Google
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).
Potential Drawbacks 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 o 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.
