Income Tax

Question 1

What are the effects of gov lowering income tax?

Answer 1

Lower income tax rates increase the spending power of consumers and can increase aggregate demand, leading to higher economic growth (and possibly inflation).

On the supply side, income tax cuts may also increase incentives to work – leading to higher productivity.

Question 2

What factors determine the effect of a tax cut?

Answer 2

the effect of tax cuts depends on

1 how the tax cut is financed

2 the state of the economy and

3 whether low tax rates actually increase productivity and the willingness to work.

Question 3

1 How might an income tax effect the supply side of the economy?

Answer 3

Lower income tax rates may encourage people to work longer.

This is the substitution effect – work is more attractive with lower tax rates.

Question 4

2 How might an income tax effect the supply side of the economy?

Answer 4

However, there is also the income effect. With lower tax rates (and effectively higher wages), it is easier to get your target income by working fewer hours.

Therefore, tax cuts may not increase labour supply because people don’t need to work more if work is more highly paid.

Question 5

Explain the laffer curve

Answer 5

A controversial economic argument is the “Laffer Curve“. This argues that if you cut income tax rates, then the tax cut increases the incentive to work so much, that the government can actually gain more tax revenue. It seems to offer the best of both worlds – lower tax rates and higher tax revenues.

Question 6

what does the laffer curve look like?

Answer 6

Question 7

Do tax cuts really increase productivity and economic growth?

Answer 7

There is a debate about the extent to which tax cuts increase productivity and economic growth. If marginal income tax rates are very high, e.g. 80%, then cutting tax rates is likely to increase labour supply and productivity.

But, with tax rates of 20 or 30%, cutting income tax rates is no guarantee of increasing productivity and growth.