LS17 + LS19 + LS21 - Taxation, Public Sector Finances, Macro Policies In A Global Context Flashcards
Types of taxation
Progressive taxation - as income rises, larger % of income is paid in tax- income tax
Proportional taxation - % of income paid as tax is constant so matter level of income
Regressive taxation - as income rises, smaller % of income is paid in tax -VAT
Laffer curve
Relationship between tax rate and tax revenue - tax revenue is not maximised at 100% as workers are disincentivsed to work, so less tax revenue
It shows that if you raise taxes on the rich to the point where total revenue decreases as tax rate increases.
higher income tax = disincentive for workers to work for higher incomes as heavily taxed. The income effect becomes negative whereby workers work -earn less to reach satisfactory income = reducing income tax revenue. Higher taxes promotes tax evasion/ avoidance and incentivising the highly skilled workers/entrepreneurs to emigrate to countries where tax rates are lower. Not only will this reduce expected tax revenue for gov to use in redistributing income - dampen productive potential as innovation/ entrepreneurial spirit decreases. Free market
Example – France raised income tax around 2015- Brain drain
Lower tax rates – substitution effect > income effect- substitute leisure for more work- hence tax rev increases
DIAGRAM: Tax rate increases up to point A, will result in an increase of tax revenue. Further tax rate increases from A to B result in a loss of tax revenue from C to D
Economic effects of changes in tax (incentives to work)
High marginal rates of tax = discourage individuals from working. free market economists argue - the supply of labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as individuals work longer hours, accept promotions and more people join the workforce.
§ High taxes on high income earners could encourage them to move abroad and taxes on the poor may lead to a poverty trap.
§ high income tax reduces incentives more than high vat. thus, a switch from direct to indirect taxes may increase incentives.
§ However-no hard evidence for the link between income tax and incentives. Nordic countries have high taxes and welfare benefits but have similar rates of growth compared to lower tax and gov spending countries like US and UK.
§ It can be argued that higher taxes mean people have to work longer hours in order to maintain their income and so even increases the incentive work
In 2022, the Adam Smith Institute calculated that average earners in the UK work from the 1st January to the 8th June (Freedom Day) to pay their taxes - all income after that point belongs to them
Economic effects of changes in tax (real output and employment)
Some taxes affect AD whilst others affect AS. A rise in direct taxes will reduce the level of disposable income =fall in their spending = fall in AD. It could also cause a fall in leftover profits for businesses and therefore a fall in investment. The effect this has on output will depend on where the economy is: whether it is at full employment or not.
Higher indirect taxes and NICs increase costs for firms = decrease SRAS. Depend on where the economy is producing.
Income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become inactive.
Economic effects of changes in tax (price level, FDI flows, trade balance)
PRICE LEVEL- An increase in indirect taxes reduces disposable income & so workers may petition their employer for a salary increase
If they receive the increase the economy may face a wage-price spiral
Indirect taxes also increase costs of production for firms possibly leading to cost-push inflation
FDI FLOWS- If the rate of corporation tax increases relative to other countries, it may result in less inward foreign direct investment
TRADE BALANCE- An increase in taxes can reduce disposable income which is likely to reduce the level of imports
This may improve the trade balance (exports - imports)
Automatic stabilisers
Feature of tax and transfer system that reduces economic activity during booms and stimulates activity during slumps, WITHOUT govt intervention
Recession - unemployment benefits; amount taxed falls –> leads to higher disposable income, more consumption to boost AD and recover economy; EV: depends on level of unemployment benefits, and taxes
Boom - people pay more in tax, unemployment benefits fall so income decreases, reduces rises in AD to prevent overheating
Discretionary fiscal policy
Fiscal policy implemented at the discretion of policy makers
Fiscal deficit
When govt spending is higher than govt revenue in a certain time period
Debt
Fiscal/Budget Deficit - when govt spending is higher than govt revenue
National Debt - govt total outstanding debt - what gov towes from budget deficits over time
Debt to GDP ratio - total govt debt as a ratio of GDP - the higher the ratio, the less likely the repayment is
Cyclical budget deficit
When budget deficit occurs due to automatic stabilisers
* recovery/boom - budget deficit falls as tax rev rises, transfer payments decrease
* downturn/recession - budget deficit rises as transfer payments increase and tax revenue falls
Structural budget deficit
Part of budget deficit that occurs due to discretionary fiscal policy rather than automatic stabilisers
Factors influencing deficit
State of the economy - if economy in boom, higher incomes/profit, higher spending so govt is earning more tax revenue and paying out less unemployment benefits - reduce budget deficit
Age distribution - more ageing population, so higher dependency ratio –> higher pension/healthcare payments and lower tax revenue, so budget deficit rises
Discretionary Fiscal Policy - used to recover out of recession, or appease political supporters - increases budget deficit
Impact of budget deficits and national debt
Interest Rates - if government services deficit through borrowing money, interest rates rise, increasing cost of borrowing for all agents
Debt Servicing - greater national debt leads to larger dept repayments, so debt servcing becomes harder, especially if interest rates are high, worsening the budget deficit and national debt
Intergenerational Equity - increasing debt through budget deficits can be seen unfair to future generations as they pay for it through higher taxes and lower government spending. But if long term this causes GDP growth, increasing govt revenue and improving ability to service its debt
Rate of inflation - if govt services debt through issuing bonds (borrowing), then the G of AD rises, with private sector components fall by an equal amount, so AD doesnt rise. If govt prints money instead, then AD rises, plus more money chasing same goods leads to demand pull inflation
Credit Ratings - credit rating is likely to fall if debt to GDP ratio rises as creditworthiness falls
FDI - high debt to GDP ratio reduces investor confidence as it is deemed a credit risk with low return on their investment, so inward FDI falls
Factors influencing national debts
Size of fiscal deficits- As national debt is the accumulation of annual fiscal deficits, the size of the fiscal deficit each year will grow by the size of the deficit
If the UK were to run a budget surplus in any year, this additional revenue could be used to pay back some of the debt - or it may be used to fund government spending or investment in the following year
Government polices- These directly impact tax revenue & government spending which can change the level of the fiscal deficit leading to a change in the national debt level
E.g. Reducing corporation tax during a boom in the economy will reduce government revenue & possibly increase the deficit & national debt at a time when the deficit would naturally be decreasing due to the automatic stabilisers
Significance of the size of deficits and national debts
High levels of borrowing may raise interest rates in economy since an inc in demand for money will increase the price of money, i.e. interest rates= crowding out of the economy. However, this may not always be the case as the government may borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged.
Countries have to spend a large amount of money on servicing their national debt through interest repayments, which has a high oppourntiy cost. impact will depend on the level of interest rates and the size of the primary deficit compared to interest repayments. In a liquidity trap ( when interest rates are extremely low), the government can often borrow at very low rates for a long time.
Some economists argue- high fiscal deficits nd national debts benefit citizens today at the expense of future generations- can cause intergenerational inequality. . Concerns over a deficit depend on whether the deficit is caused by current expenditure alone or whether it is just caused by capital expenditure. A current budget deficit is one where government revenues are less than current expenditure; the GOV has to borrow money simply to finance day to day spending. It is argued that the government should run a current budget surplus to enable it to invest for the future, except in recessions when they can run a deficit to increase AD. A current budget deficit is problematic as it means that future generations are forced to pay the bill for today’s expenditure
HOWEVER-
However, if the deficit is due to capital expenditure, the future generations benefit from increased spending and so their extra tax bill to pay for today’s borrowing can be justified. The value of debt tends to fall overtime because inflation erodes its value and because a country’s GDP grows meaning the debt is easier to pay off, so this limits the impact on future generations.
Monetarists argue that more money chasing same amount of goods= price increases. High deficits can cause inflation. Gov inc spending – AD will rise. if a government is unable to borrow money, they will print more money and this can cause hyperinflation. Printing money will not necessarily cause hyperinflation, it depends on how much is printed and where the economy is producing on the LRAS
High levels of debt tend to result in reduced credit rating for GOV. Private sector companies estimate likelihood that gov will default on its debt and give it a rating from AAA to D. Lower credit ratings mean that lending to the government is riskier and so higher interest rates are demanded from lenders. E.G. Greece.
However, in reality, not the size of the debt that influences the level of risk involved with the lending the money, it is whether that country has ever defaulted on their loans before and their current economic/political climate.
EV; government borrowing can benefit growth if it used for capital spending since this will improve the supply side of the economy = reduce the deficit in l/t. On top of this, the budget deficit can be used as a tool for short term demand management: Keynesians argue a deficit is acceptable to use as a stimulus in demand during recessions.
