4.5.2 - Taxation Flashcards
What is a progressive tax ?
A tax rate that increases as taxable income increases.
Picture = UK income tax, check currently as it might have changed.
What is a regressive tax ?
A tax that takes a larger percentage of income from low-income groups in comparison to high-income groups.
Example : VAT (20%) - is considered regressive because people with low incomes are affected more than those with higher incomes from the tax that comes with the purchase. The result is that low-income earners pay a higher percentage of their income on sales tax.
Proportional taxes (flat taxes)
A constant tax rate to all income levelsThis means that individuals pay the same percentage of their income in taxes, regardless of their income.
Example : VAT (20 %) - VAT
How does higher tax rates effect incentives to work ?
- Higher tax rates may reduce the incentive for employees to work as they will have lower disposable income disincentivising them to continue working. Additionally it will also disincentive them to worker harder for promotions, and to work for longer hours and they will retire earlier as even if they do earn a higher income they will still be taxed even more. Reducing productivity and efficiency of labour.
beyond spec :
This may lead to the substitution effect as higher tax rates, may mean that workers will choose more leisure over work because the extra income they earn is taxed at a higher rate.
However, some individuals may work more hours to maintain their desired level of income, known as the positive income effect. The overall impact on labor supply depends on which effect is stronger.
- Decreasing indirect taxes such as VAT will also decrease the incentive to work as good and services will become cheaper so people won’t have to be earning as high of income to purchase basic goods and services. Therefore won’t have to work as hard.
Eval : May lead to increase in consumption in the economy-demand pull inflation.
How does lower tax rates effect incentives to work ?
Lower direct tax rates (e.g., income tax) may increase the incentive for employees to work as they will earn higher disposable. This can encourage people to work longer hours, seek promotions, retire later and incentives the economically inactive to enter the workforce, leading to increased productivity and efficiency of labor.
Beyond spec:
* This may lead to the positive substitution effect, where lower tax rates increase the attractiveness of working over leisure.
* However, some individuals may work fewer hours due to the negative income effect, as they can achieve their desired income with less effort. The overall impact on labor supply depends on which effect dominates.
Higher indirect tax rates (e.g., VAT) may increase the incentive to work because goods and services become more expensive, requiring individuals to earn more income to maintain their standard of living.
Evaluation:
* Regressive effects: Higher indirect taxes disproportionately affect lower-income individuals, in comparing to higher-income individuals which may lead to more inequality.
What is the diagram for the Laffer curve ?
Explaining the laffer curve
- Increasing tax rates will increase tax revenue.
- However after the efficient tax rate (gov are unsure of what exactly this tax rate is) then tax revenue will start to decrease even though tax rates are increasing.
- This is because :
1. Greater incentive to evade taxes (illegal) – i.e. non–declaration of income and wealth
Also tax avoidance
2. Lower disposable income so workers are disincentivised to work.
3. People begin to move to other countries with lower tax especially the highly skilled workers leading to possible brain drain (emigration)
Explain the effect of a increase in tax on income distribution.
- An increase in income tax will make the tax system more progressive, so more money is proportionately taken from the rich than from the poor making income distribution more equitable.
- Increase in inheritance tax means the wealthier will be taxed more and won’t be able to keep as much of their wealth. This helps improve income distribution.
- Increase in VAT (which has regressive effect) would mean that lower income earners will spend more of their income on one good in comparison to a higher income earner. Increasing income inequality.
Explain the effect of a decrease in tax on income distribution.
- A decrease in both the high and low income earners will mean that higher income earners will have more disposable income. Increasing income inequality.
- A decrease in indirect taxes e.g VAT will increase the purchasing power of lower income earners, it also means that goods and services become cheaper for them which may help to improve their living standards. Improving income inequality and narrowing the gap in livings standards.
Eval : However lower VAT will benefit the higher income earners even more so their may be an increase in consumption which may lead to demand pull inflation eroding the purchasing power especially for lower income households. Worsening income inequality.
2. reduction reduces government tax revenue, possibly leading to cuts in welfare programs, education, and healthcare, which are crucial for reducing inequality
What is the effect of a increase in Tax on Real output and employment.
- Increased income tax and VAT reduce households’ disposable income, leading to lower marginal propensity to consume (MPC).
- This causes aggregate demand (AD) to shift left, leading to a fall in real output (Y to Y1) - draw
- As consumption falls, firms experience lower demand for goods and services.
- Since labour is derived demand, firms may reduce hiring or even lay off workers to reduce cost, which increases unemployment.
- Increased income tax discourages the economically inactive from joining the workforce, as they receive a smaller reward for working compared to welfare benefits.
- If corporation tax rises, firms face higher costs, leading to SRAS shifting left, further decreasing real output (Y to Y1).
- Firms may cut investment, reducing long-term economic growth.
Eval :
* Higher tax revenue allows the government to subsidise markets like energy or transport, reducing costs for firms and shifting SRAS right in these sectors.
* This could offset some of the negative effects on output and employment
* If tax revenue is used to improve education and job training, it could increase labour productivity and long-run employment, counteracting short-term job losses.
- This could lead to a rightward shift in LRAS, boosting potential output.
What is the effect of a decrease in Tax on Real output and employment.
- Decrease in income taxes would increase the amount of disposable income households have. Causing an increase in consumption (mpc). Which would cause AD to shift right (explain this how diagram) y-y1 would show that output is increasing.
- An increase in AD due to an increase in disposable income will decrease unemployment as labour is demand derived .
- A decrease in tax rates will also incentives the economically inactive to join the labour force because they know that they will have more disposable income if they worked rather than relying on welfare payments.
- A decrease in corporation tax will also decrease costs for firms so SRAS shifts right leading to an increase in real output. (Y - Y1).
Eval :
- Gov receives less in tax rev so they can subsides markets like the energy market so SRAS in industries lie this may fall.
- Also there may be reduce spending on education and training which may limit the ability for the economically inactive to join the labour force so there may not necessarily be a decrease in unemployment.
Effect on an increase in taxes on the price level
- Increase in direct tax, reduced disposable income. Reducing mpc and consumption. Ad shifts to the left reducing price level (diagram).
Eval : elasticity of goods and services in the economy as if it is a necisty good then consumption will not be reduced so price levy won’t change. - Increase direct and indirect taxes increases cost of production for firms, causing SRAS to shift left which may cause the price level to increase. (Cost push inflation).
- Additionally if firms reduce investment due to higher corporation taxes, long-run productive capacity may fall, worsening future inflation.
Eval : The extent to which cost push inflation occurs is dependent upon whether firms absorb the tax or pass it on to consumers.
Effect on an decrease in taxes on the price level
- A decrease in income tax increases disposable income, raising the marginal propensity to consume (MPC) and boosting consumption (C).
- This shifts AD to the right, increasing the price level (P to P\1) in an AD-AS digram.
- However, a reduction in VAT or corporation tax decreases firms’ costs, allowing them to lower prices or invest more in production.
- This shifts SRAS to the right, potentially reducing the price level and offsetting demand-pull inflation.
Eval: * The extent of price level decreasing depends on whether firms pass cost savings to consumers or increase profit margins instead.
* Additionally Lower corporation tax incentivises firms to increase investment, improving productivity and expanding long-run aggregate supply (LRAS).
* This helps control inflation in the long run by increasing the economy’s productive capacity.
Note :
When speaking about the effects of taxes always consider if both direct and indirect taxes will increase, or if only one increases and another decreases which will have different effects on consumption, AD, price level, employment and output.
Note
- Always remember to talk about the effects of both tax changes e.g if a direct tax decreases but an indirect tax increases
Effects of increase in tax on the trade balance
- Increase tax, reduces disposable income. Which would decrease the marginal propensity to imports so imports will decrease improving the trade balance.
However :
- Increase in indirect tax will make goods ad services in the Uk more expensive, so cost of living in the UK increase. As a result consumers may decide to switch to cheaper imported alternatives reducing the demand for domestic goods and causing imports to increase.
- Note : An increase in VAT has no impact on the price of imports. Most indirect taxes are placed on goods which are made and sold in the country. However tariff will affect the price of importing from other non - UK countries. Which will affect how much they import affecting the trade balance as this means we may export more or less.
Eval : depends on how much more cheaper international goods are compared to UK goods.
- Depends on shipping times for that good.
Effects of decrease in tax on the trade balance
- Decrease in direct tax, will increase disposable income. Which would increase the marginal propensity to imports so imports will increase worsening the trade balance.
- If consumer confidence is low, households may save rather than spend, reducing the expected increase in imports.
- Also a decrease in indirect taxes will make UK good and services cheaper to purchase. This will decrease the cost of living in the UK, so domestic goods are more attractive to UK consumers so the marginal prospenisty to import decreases, imports decrease and trade balance therefore improves.
Eval :
- If imported alternatives are still cheaper despite the tax cut, consumers may continue buying imports, limiting the effects.
Explain the effects of an increase in taxes on FDI flows
- Higher corporate or direct taxes reduce post-tax profits for firms.
- This makes the host country less attractive to foreign investors since the net returns on their investment are lower.
- Increased taxes might also raise the overall cost of doing business (e.g., through compliance costs).
- However, if higher taxes are used to improve public services or infrastructure, this could partially offset the negative impact by enhancing the business environment and reducing operational risks.
Explain the effects of an decrease in taxes on FDI flows
- Lower corporate or direct taxes increase post-tax profits for firms operating in the host country.
- Higher profitability makes the country more attractive for foreign direct investment (FDI), as. investors expect better returns.
- Lower taxes often signal a stable and business-friendly policy environment, reducing uncertainty about future fiscal burden.
- This increased certainty can boost investor confidence, encouraging long-term FDI commitments.
Rember
Where you can talk about how increase in direct taxes will decrease profits, which is likely to reduce investments leading to a decrease in AD affecting price levels, real output, unepoylment
A
C
A
