Question: What are the effects of reducing tax?
Let us take the example of a cut in the basic rate of UK income tax from 20% to 18%
In this case, workers will see an increase in their discretionary income. With lower income tax rates, they would keep more of their gross income, so effectively they have more money to spend.
In this case, we could expect to see a rise in consumer spending because workers are better off. (AD=C+I+G+X-M). Because consumers spending is a component of AD (roughly 60%) then a rise in consumer spending should cause a rise in aggregate demand (leading to higher economic growth)
But, does a cut in tax really increase aggregate demand? Firstly, it depends how the tax cut is financed.
- Suppose the government offer £4 billion of income tax cuts, but at the same time cut £4 billion from welfare spending. In other words the tax cut is financed by cuts in government spending. In this case, we will not see an increase in AD because some people are better off from the tax cut, but others will cut their spending due to lower welfare payments.
- Alternatively, the government could finance the tax cut by increasing government borrowing. Would this increase AD?
- In a recession, we probably would see higher AD. This is because the government borrowing will be financed by people wanting to save anyway. In this case, the government is injecting unused resources into the circular flow. In a recession, the tax cut makes a big difference to people’s spending power
- If the government increases borrowing in a boom to finance a tax cut, we may get crowding out. This essentially means the government borrow more by selling bonds to the private sector. If the private sector buy government bonds, they have less money to invest elsewhere. Also, during high growth, higher borrowing may lead to higher bond yields and these higher interest rates cause financial crowding out.
- If the tax cut is financed by by higher productivity, rising tax revenues, and a growing economy, then this is more likely to allow higher consumer spending.
Impact on Productivity
If we take a cut in income tax, it could also have an effect on the supply side of the economy.
- Lower income tax rates may encourage people to work longer. Overtime is more worthwhile if you get to keep more of your income. This is the substitution effect – work is more attractive with lower tax rates.
- 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.
There is much debate about the extent to which tax cuts increase productivity and economic growth. If marginal tax rates are very high e.g. 80%, cutting tax rates is likely to have some increase in labour supply and productivity. But, with tax rates of 20 or 30%, cutting income tax rates is no guarantee of increasing productivity and growth.
Cut in indirect tax
If the government cut an indirect tax like VAT, the effect is similar. If goods are cheaper because of lower tax, consumers will effectively have more purchasing power. After buying the same number of goods, they will have more money left over, therefore consumer spending may rise.
Again the effect depends on the state of the economy.
For example, cutting VAT at the start of the recession was expansionary fiscal policy and helped to make consumer spending higher than it otherwise would have been.
Other impacts of a cut in tax?
- It depends on consumer and business confidence. If consumer confidence is low, then a cut in tax may not increase spending because they prefer to save the extra income. Alternatively, some argue, that lower tax will increase confidence and general motivation because they feel less government intervention.
- It depends what else is happening in the economy. If we cut tax, during a global recession, AD may continue to fall. Even though tax cuts are helping to increase disposable income, we will see a fall in exports, fall in house prices, and a rise in unemployment. In other words, the expansionary effects of tax cuts are outweighed by other factors in the economy.
- It depends which taxes are cut. If you cut excise duty on alcohol and tobacco, then many people on low income will see a significant increase in discretionary income, this is likely to be spent. If you cut higher marginal tax rates (e.g. 50% tax rate on incomes over £100,000) this is more likely to be saved. People earning over £100,000 have a lower marginal propensity to consume – they can afford to save. Therefore, if you cut tax for high earners, there will be a smaller impact on increasing AD, than cutting tax for low income earners.