The effect of tax cuts

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)
AD-increaseBut, 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?

  1. 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.
  2. 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.
  3. 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.

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An end to globalisation?

Readers Question: Why doesn’t WTO make into law that all manufactured goods should either be assembled or made in the continent where its been sold? There is so many reason why this should be put in place in our globalised world

saltaire-mill-factory-river

Saltaire Mill Yorkshire. UK once exported clothes, now we import.

I don’t agree. The benefits of a globalised world are that we can benefit from goods and services produced in many different continents.

If Japan is relatively better at producing cars, it makes sense for Latin American, Asian and African countries to import cars and concentrate on producing goods where they have a comparative advantage.

Would it help Africa to insist they only bought cars manufactured in Africa?

No, it wouldn’t help because, at the moment, they don’t have a developed car industry. It would take a long time, and cost a lot of money in investment to start producing cars. African nations can’t afford to devote a high percentage of GDP to developing a car industry, when they would gain more benefit from investing these scarce resources into education, infrastructure and health care.

If you made a law that only African cars could be sold in Africa, you would probably see a large fall in the quantity of cars bought and so many Africans who could have bought an imported car are now no longer able to drive a car. This would have an adverse effect on African economies.

Would it help the UK to be unable to import clothes from Asia?

If the UK had to produce its own clothes, it would have to restart its own textile industries. These labour intensive industries would take workers away from relatively more productive industries in the service sector. Because of higher labour costs in the UK, it would also lead to more expensive clothes, and lower discretionary income for consumers. Because we would spend more on domestically produced clothes, other UK industries would suffer from the decline in spending.

If Asian countries like Pakistan, India, China are unable to export clothes to the West, these textile industries would effectively close down. This is because many Asian clothing factories are specifically built for export markets. If factories closed down it would lead to unemployment, falling wages and lower GDP.

Economies of scale

Another problem with discouraging international trade is that we would see lower economies of scale. If each country / continent had to produce its own aircraft, we would need more smaller firms. Therefore, we would get higher average costs and less efficiency. Global production enables significant gains from economies of scale – leading to lower prices.

Are there any arguments to encourage manufacturing in developing economies?

If we take a less extreme view, we could say there are good reasons to consider policies which help promote manufacturing industries in developing economies. For example, many African countries have a comparative advantage in primary products. But, this can limit long-term development. There is the infant industry argument which makes a good case for allowing developing countries some tariff protection to encourage diversification. But, this is different to a complete ban on importing goods from other continents.

WTO

Also, it should be remembered the WTO doesn’t have the authority to implement such a law. It is set up to help resolve trade disputes not to implement law prohibiting trade.

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Different ideas of tight monetary policy

Readers Question: I only recently discovered your site, which is spectacular, and have been reading every article since then. However, I found that two of your articles are contradicting. In your article “Problems of Deflation” you state that the current monetary policy of the EU is tight due to 0.5% inflation and interest rates.

In your article about tight monetary policy though, you state that tight monetary policy could include open market operations and rising interest rates.

I was hoping that you would help me solve my misunderstanding.

It is a good question. Firstly tightening of monetary policy implies that the Central Bank is trying to reduce demand for money – and reduce the rate of economic growth. Tight monetary policy implies high real interest rates. Tightening of monetary policy usually involves higher real interest rates.

The most simple example of tight monetary policy would involve increasing interest rates.

  • Higher interest rates increase the cost of borrowing, increase the cost of mortgage payments and reduce disposable income – this leads to lower consumer spending and lower economic growth
  • Alternatively in theory, the Central Bank could try and reduce the money supply. For example, printing less money, or sell long dated government bonds to banking sector. This is very roughly the opposite of quantitative easing. Though open market operations haven’t been used in practise for quite a while.

How can you have tight monetary policy with low interest rates?

inflation-base-rates-since-03

A potential confusion is why do economists talk about tight monetary policy when interest rates are 0.5% or zero – like in the current climate?

If you have a quick glance of an economics textbook, zero interest rates imply loose monetary policy – low interest rates make borrowing cheap, mortgages cheap, and in theory should encourage spending and a higher rate of economic growth. Continue Reading →

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Economic issues for the UK General Election

I’m off to New York on Wednesday, I’m tempted to stay until May 8th, so I can miss the UK General election campaigning, which so far has been quite depressing for the poor quality of economic debate.

This is just an outline of some issues for consideration. I may expand upon these in the coming weeks.

Whose fault was the 2008/09 economic crash? –

Essentially a global financial crisis, exacerbated by weak financial regulation. But, who was advocating much stricter regulation of the banks pre 2007?

See: who is to blame for great recession

Would the great recession have been worse?

Yes:

  • if UK had been in EURO.
  • If UK had not pursued expansionary fiscal policy in 2009
  • If Bank of England had not pursued expansionary monetary policy

Was the great depression caused by reckless government borrowing under Labour?

uk-national-debt

In 2007/08, UK public sector debt was close to the lowest level achieved since before the First World War in 1914.

See also: Government debt under Labour

Note debt levels in 1945, when Labour introduced NHS, welfare state and nationalised key industries!

Is reducing the budget deficit an important economic objective – when the economy is recovering from recession?

Reducing debt may be an important political objective. But, ironically, many economists feel that reducing deficits (through austerity) can be counter-productive.

Why is austerity so politically popular, when so many economists state it is damaging?

What is the economic impact on immigration on the UK economy?

Many benefits for tax revenue, labour supply, economic growth and reducing debt to GDP. Though it does add to the added pressure on housing market, congestion and transport.

See: Economic effects of immigration

Economic record of the coalition

 1. Economic growth

real-gdp-growth-00-14-trend-line

Economic recovery – better than Europe.

Recovery came, but did period of austerity in 2011 unnecessarily delay the recovery? Should the recovery have been much stronger? Have we permanently lost output? Austerity pros and cons Continue Reading →

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Types of deflation

Readers Question: I have just been reading your opinion on deflation. You say generally it’s bad unless it is caused by  production and technology improvement. My question is this, how would the consumer know the difference ?

Consumers wouldn’t really notice the difference why prices are falling. The key thing is what happens to their nominal wages – and therefore their effective purchasing power.

If we have ‘good’ deflation – due to a big increase in productivity, lower costs – then in theory firms will be able to pay real wage increases. With this type of deflation, we are seeing lower prices, but also higher output, higher productivity, higher profits – and hopefully higher wages. If consumers see lower prices, but they have rising incomes, then you would expect higher spending because they will have the money to buy these cheaper goods.

If we have ‘bad’ deflation – falling prices caused by weak demand, then firms will be seeing a decline in profitability. In this circumstances firms will not be increasing wages, but trying to cut wages. Also, if firms can’t cut nominal wages, we may see a rise in unemployment (a combination of real wage unemployment and demand deficient unemployment).

Therefore, in this scenario of lower wages / higher unemployment, the falling prices will not be sufficient to encourage spending and higher consumption. Instead people will be risk-averse trying to save and waiting for prices to fall further.

Readers Question: And regardless of the reason people should put off buying shouldn’t they?

It can depend a lot on consumer confidence and expectations of future wages / employment opportunities. If we have a period of deflationary pressures – low /negative growth, then people may be fearful about future employment opportunities, they will expect low wage growth, and possibly unemployment – therefore, in this circumstances, consumers will be trying hard to be careful in budgeting and spending. If they think prices will fall and their income may decline, then this is an added reason to delay spending.

However, if there is strong growth, low unemployment and rising wages, there is much less need to be careful with spending – therefore, they will be willing to buy now and enjoy their rising real wages.

Continue Reading →

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Effects of Zero inflation on Aggregate Demand (AD)

Readers Question: I was really hoping you might be able to inform me of the effects that zero inflation (which the UK is currently experiencing) might have on aggregate demand in the economy?

Firstly, this post will help consider the impact of zero inflation on AD and economic growth  – Is zero inflation a good thing?

To add a few things to this. Let us look at an AD curve

Aggregate Demand CurveAD-curve

If we look at an aggregate demand curve, we usually assume that a lower price level causes a movement along the AD curve (and higher AD).

Therefore, zero inflation should, in theory cause higher AD. The AD curve is sloped like this because:

  • A lower price level, ceteris paribus, gives consumers more disposable income. Assuming constant nominal wage growth a fall in the inflation rate, will give consumers more income, and so they will be more willing to spend.
  • A lower price level will, ceteris paribus, make UK goods more competitive and therefore encourage UK exports (X is a component of AD)
  • At a lower price level, interest rates usually fall, encouraging more spending (see effect of lower interest rates.)

However

  1. This simple model of AD – plotting Price Level (PL) and National Income (Y) is an over-simplification. We talk about a lower price level, when often we mean just a fall in the inflation rate. I’m often uncomfortable with this model that slips in between price level / inflation rate. But, for A – Level economics at least, we don’t make the model more complicated.
  2. The UK has seen a fall in the inflation rate to zero, but this fall in the inflation rate has occurred in many other European countries (some EU countries have experienced outright deflation), therefore the UK has not seen a big boost to competitiveness, and we would not expect a big rise in export demand as a result of zero inflation. Furthermore, the European economy is sluggish, there is weak export demand – even if we were more competitive.
  3. Interest rates have been at 0.5% since March 2009, so with this fall in inflation to zero, monetary policy has effectively become tighter – real interest rates have increased.

Continue Reading →

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Is zero inflation a good thing?

In the UK, CPI inflation has fallen to 0%. Is this a cause for celebration or a cause for concern?

inflation-monthly-cpi-90-15-with-target

Firstly the government set an inflation target of CPI 2% +/-1 for good reasons. The fear is that if inflation is too low, we may start to get problems associated with deflation. More details here About the problems of deflation. But a quick summary:

  • Rising real value of debt. With low inflation, it becomes harder than expected for people to pay back their debts – they have to spend a higher % of income on debt repayment leaving less income for other spending.
  • Rising real interest rates. The fall in inflation increases real interest rates, whether we like it or not. Rising real interest rates make it less attractive to borrow and invest; it encourages consumers to save. If the economy is depressed, this rise in real interest rates can make monetary policy less effective in encouraging growth.
  • Falling prices can encourage people to delay buying expensive luxury goods – they feel they need to wait a year because prices will be lower.
  • Low inflation is an indication of low growth. A normal period of economic growth would typically give a moderate rate of inflation (2%). If inflation has fallen to 0%, it suggests that there is intense price pressure to encourage spending and the recovery is very fragile.

Evaluation

We have to look at the reason why inflation has fallen. At least part of the fall in UK inflation is due to temporary short term factors, such as falling oil and petrol prices. These temporary factors are unlikely to continue, and could be reversed. It is more important to look at underlying inflationary pressures – core inflation, which excludes volatile prices like food and oil. For example, other measures of inflation like – RPI  is 1% (even though RPI is not the same as core inflation.)

Falling prices could boost real incomes. One of the fears of deflation is that it depresses consumer spending. However, with a fall in the price of basic necessities like petrol and food, consumers find their discretionary income / spending power has increased, this could actually lead to higher spending in the short-term. Continue Reading →

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UK Inflation Rate and Graphs

Current UK Inflation Rate

  • CPI inflation rate: 0.0% (headline rate)
  • (page updated 25 March, 2015)

inflation-monthly-target

What is causing the fall in inflation?

  • Lower cost push inflation – falling oil prices
  • Other commodity prices also falling, such as metals, food.
  • Lower energy prices – gas and electricity
  • Low worldwide inflationary expectations. Europe is experiencing deflation and this is keeping inflation low.
  • Supermarket price wars, with big chains, such as Tesco and Sainsbury attempting to maintain market share from Pound Shops and discounters like Lidl
  • Wage growth still weak, despite early signs of some wage growth.
  • Note: RPI inflation is still 1.0%. Also, core inflation stripping out volatile items such as petrol, oil and energy prices is higher than the headline CPI rate.

Historic inflation

uk-RPI-inflation-1948-2014

The current UK inflation rate compares favourable to much of the post-war period. The 1970s frequently saw double digit inflation. In 2014, the annual RPI was 2.2%.

See also: more historical graphs of inflation

Inflation since 1990

inflation-monthly-cpi-90-15-with-target

CPI and CPIH

  • CPIH – 0.3% in the year to Feb 2015

CPIH is a new experimental index from the ONS. It is based on CPI, plus it includes housing costs, such as mortgage interest payments. Owner occupiers cost (OOH) account for 12% of the CPIH weighting. Mortgage interest payments are the biggest part of OOH. Mortgage interest payments average 10% of household expenditure.

cpi-cpih-inflation

Continue Reading →

Shortage of Lorry Drivers

Despite high unemployment in the UK, there is a shortage of LGV drivers and it is estimated that the UK will need an extra 150,000 drivers by 2020.

lorry-overtake-cyclist

In Nottinghamshire, it is estimated that for every nine vacancies there is only one qualified candidate. (link)

The average age of a (LGV) Large Goods Vehicle driver is 53. Only 2% of drivers are under 25.

Regular readers of this blog will know that I tend to favour green transport – Bicycles, freight by rail, solar power, higher taxes on petrol e.t.c. But, I also know that 99% of the goods that I buy are delivered by LGV vehicles. Lorries are an essential part of the economy – almost as important as perhaps coal miners were in the 1960s and 70s. If one section of workers could bring the UK economy to a standstill, it is LGV drivers.

Why Shortage of Lorry drivers?

1. We don’t value vocational careers / qualifications. Young people don’t see a career in logistics as a long-term career. As a society, we tend to place less value on non-academic qualifications which are essential for the economy.

2. Lack of funding for driver training. It costs £3-£5,000 to gain the necessary qualifications to become a LGV drivers; and only 50% of applicants pass the test. This seems a lot. (Here the Daily Mail blames the shortage of lorry drivers on the EU Regulations which require good driver training – the mandatory Certificate for Professional Competence.)

But, compared to the cost of a three year university degree, training for LGV training is a fraction of the price. (BTW: Given the importance and potential danger of driving LGV vehicles, it is quite right we have very high standards. EU regulations could save lives. The problem is that as a society we are happy to spend £100,000 to put a student through three years of university to get a degree, but we are reluctant to spend £5,000 on LGV training.) Continue Reading →

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Fall in Euro

Recently, the Euro has fallen from 1.5 Dollars to 1 Euro in 2011 to near parity in March 2015.

Fall in Euro

The fall in the value of the Euro has been very steep in the last six months.

This is a very significant depreciation in the Euro, and primarily reflects the greater economic weakness in the Eurozone. Related to the economic weakness, is the decision of the Eurozone to recently begin expansionary monetary policy (quantitative easing).

Why the Euro is falling

1. The ECB are embarking on Quantitative easing – the creation of money to purchase government bonds. Quantatitive easing tends to reduce the value of a currency because:

  • This increase in the money supply tends to reduce the value of the currency (greater supply tends to reduce price.)
  • Q.E raises expectations of higher inflation  – higher inflation tends to reduce the value of a currency because it will become less attractive to buy EU goods.
  • Also purchasing government bonds will reduce bond yields in Europe, making it less attractive for private investors to save money in the Eurozone – you get a lower return on Eurozone assets. Investors would rather save in US assets, where interest rates are more likely to rise and you will get a better rate of return.

2. General weakness of the Eurozone economy. Some analysts believe that EU’s quantitative easing maybe a case of too little too late; they believe Q.E. in Europe may actually have a quite limited effect. This is due to two factors: Continue Reading →

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