4.5.2 Taxation

Question 1

Why do govts levy taxes?

Answer 1

to raise finance for spending:
- to correct market failure
- to redistribute income
- to manage the economy - macro policy/fiscal policy/interventionist supply side

Question 2

Why do govts change level of taxation?

Answer 2

• to manage the economy e.g. increase or decrease AD
• impact on AS through the effect on incentives

Question 3

What is progressive tax?

Answer 3

• as income increases the proportion of income taxed increases
• e.g. income tax

Question 4

Purpose of income tax?

Answer 4

Increasing the rate of income tax for the higher earners makes the distribution of income more equal

Question 5

Personal allowance of income tax?

Answer 5

• 0% tax on earnings up to £12,570
• basic rate: 20% tax on earnings between £12,571 and £50,270
• higher rate: 40% tax on £50,271 to £125,140
• additional rate: 45% on over £125,140

Question 6

What is proportional tax?

Answer 6

• proportional taxation leaves the distribution of income unchanged
• e.g. if income tax was 20% for all levels of income

Question 7

What is regressive tax?

Answer 7

• takes a greater proportion of a smaller income
• does not take into account an individual’s ability to pay
• other things being equal indirect taxation makes the distribution of income less equal

Question 8

What is direct taxation?

Answer 8

• taxes on income, wealth + profits

Question 9

Examples of direct taxation?

Answer 9

• income
• national insurance
• capital gains
• inheritance

Question 10

What is indirect tax?

Answer 10

• taxes on expenditure

Question 11

Examples of indirect tax?

Answer 11

• excise duties = lump sum/specific e.g. petrol
• ad valorem = VAT - taxed as a percentage of the value added

Question 12

What are the effects of taxation?

Answer 12

• incentive to work (supply side)
• tax revenue
• income distribution
• real output + employment
• the price level
• the trade balance
• FDI flows

Question 13

Positive impact of cuts in income tax on incentive work

Answer 13

• a rise in real (disposable) wage increases the opportunity cost of leisure
• therefore higher wages will cause people to be incentivised to worker longer hours via substitution effect
• at the lower end of wages cuts in income tax can encourage people to enter the workforce - especially alongside a reduction in benefits
• the gap between being in work and out of work grows

Question 14

Negative impacts of cuts in income tax on incentive to work?

Answer 14

• the opposite effect may happen - with higher income individuals seek to take more leisure
• a cut in income

Question 15

Backward bending supply curve?

Answer 15

• in labour markets
• means after a certain point (target wage) higher wages can lead to a decline in labour supply
• this occurs when higher wages encourage workers to work less + enjoy more leisure time
• income effect outweighs substitution effect

Question 16

Criticisms of the backward bending supply curve?

Answer 16

• assumes workers can change their hours
• some workers are paid a salary (independent of hours)
• also some workers have zero hours contracts

Question 17

What does the laffer curve show?

Answer 17

• as taxes increase from low levels, tax revenue collect increases
• it also shows that tax rates increasing after a certain point (midpoint) would cause people not to work as hard or not at all = reduced tax revenue
• eventually if tax rates reach 100% then no one would work
• govt would like to be at mid point = point at which maximum amount of tax revenue is collected while people continue to work hard

Question 18

How could the laffer curve be used as evaluation?

Answer 18

increasing tax rates may not necessarily increase tax revenue

Question 19

Impact of tax cuts on income distribution

Answer 19

• impact on income distribution depends on size of cut + type of tax e.g. progressive, proportional, regressive
• cuts in income tax or increase in personal allowance will make the distribution of income more equal
• however, cuts in the higher rate tax rate will make it less equal
• increase in indirect taxes = less equal

Question 20

Impact of tax cut on real output + employment

Answer 20

• cuts in tax stimulate AD (consumption + investment) = fiscal
• AD shifts to the right
• however, imports may increase = increase real GDP if there is spare capacity in the economy (LRAS is horizontal)
• lower marginal rate of taxation could boost multiplier, other things being equal

Question 21

Impact of tax cut on general price level

Answer 21

• stimulate AD
• AD shifts to the right
• this can increase General price level if there is a lack of spare capacity in the economy (LRAS is vertical)

Question 22

Negative impact of tax cut on trade balance?

Answer 22

• cuts in tax (e.g. income tax) = increase in imports = trade balance deteriorates
• higher disposable income will increase consumption, but will also increase imports
• the extent of this will depend on the marginal propensity to import

Question 23

Positive impact of tax cuts on trade balance

Answer 23

• cuts in indirect tax (e.g. VAT) May help the UK businesses become more competitive
• their prices may be lower due to lower costs
• this may help increase the value of exports

Question 24

Impact of tax cuts on FDI

Answer 24

• lowering corporation tax, a tax on profits (supply side policy) = firms can reinvest into new products + processes
• this can attract FDI into the UK
• increase in FDI boosts AD + in the longer run LRAS

Question 25

Evaluation of impact of tax cuts on FDI

Answer 25

- TNCs invest in countries for other reasons outside of low corporation tax - e.g. quality of labour, trade blocs, infrastructure, access to suppliers

Question 26

Micro effects of tax cuts

Answer 26

- corporation tax = individual firm = fall in costs - stamp duty = house purchase, housing market = increase demand for housing - cut in petrol duty = individual consumers/households who own cars have lower petrol bill - income tax = individual/households incomes increase = more disposable income - depends on what tax bracket is cut