Russia v Europe – Impact of economic sanctions

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In February 2022, western economies imposed sanctions on Russia in response to the invasion of Ukraine. These sanctions were wide-ranging including banning exports of many goods to Russia, freezing Russian foreign reserves and recently the EU has proposed banning Russian oil exports. In response, Russia has retaliated by cutting off gas supplies to Europe causing …

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The UK’s self-imposed economic crisis of 2022 explained

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On Friday 23 September Kwasi Kwarteng the new chancellor introduced a set of tax cuts and energy price guarantees in a measure the treasury described as a ‘fiscal event.’ Yet even as he was reading out his series of unprecedented tax cuts (as share of GDP, 2nd biggest on record), markets took fright, causing the …

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Why rising interest rates would hurt the UK economy

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Interest rates are a tool of monetary policy. When the economy is overheating, the Central Bank can raise interest rates to cool demand and avoid an inflationary boom. In an ideal world, the Central Bank would make small adjustments in interest rates to fine-tune the economy and avoid booms and busts, but the situation the …

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The Effect of fall in Pound Sterling

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In recent weeks, the Pound Sterling has fallen – losing value against the dollar and other currencies. This year, the Pound has fallen over 16% against the dollar and 7% on a trade-weighted index. In Summary A falling Pound makes: UK imports become more expensive and UK exports more competitive. A falling Pound tends to …

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Will a surge in borrowing cause a debt crisis in the UK?

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As the chancellor Kwasi Kwarteng was announcing his radical budget of energy bailout, and tax cuts for corporations and high-income earners, the markets took a dim view. Sterling fell and bond yields on government debt rose as investors sold UK bonds in response to the deteriorating outlook.   Uniquely for such a large change of …

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Reasons for falling value of Pound Sterling

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Why has the Pound Sterling been falling? The Pound has been in long term decline since after the Second World War, when £1 = $4.05. In recent decades the pound has continued to decline. In particular since the great financial crash of 2007, which hit the UK hard. In recent years, the combination of Brexit, …

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Truss Economics – Will tax cuts save the UK economy?

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The UK government faces a perilous situation. In the short-term, there is a combined threat of an energy crisis, high inflation, risk of an imminent recession and a falling value of Sterling. On top of that, there are long-term problems such as climate change, a slowdown in growth and productivity, and rising debt to GDP. …

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Trickle down economics

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Trickle down economics is a term used to describe the belief that if high-income earners gain an increase in salary, then everyone in the economy will benefit as their increased income and wealth filter through to all sections in society.

How the trickle-down effect may work in theory

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If the richest gain an increase in wealth, then

  • They will spend a proportion of this extra wealth.
  • The extra wealth will cause an increased demand for goods and services, causing higher employment and a rise in wages.
  • The higher wages will also cause a multiplier effect, e.g. if more chauffeurs are employed by the rich, the chauffeur will gain increased income and, in turn, they will increase spending in local businesses.
  • A cut in taxes increases the incentive to work. Lower income tax encourages people to work longer. Lower corporation tax encourages business to invest, creating wealth.
  • Alternatively, the wealthy may invest their increased wealth. If the wealth is invested in new businesses, it will create new jobs and increase the incomes of those employed.
  • Higher spending and investment will stimulate economic activity leading to a rise in tax revenues (higher income tax, higher VAT).
  • Higher tax revenues can fund public programmes such as healthcare, education and welfare payments to the poor.

Trickle-down effect and tax cuts

An important element of the trickle-down effect is with regard to income tax cuts for the top-income earners. It is argued that cutting income tax for the rich will not just benefit high-earners, but also everyone. The argument is as follows:

  1. If high-income earners see an increase in disposable income, they will increase their spending and this creates additional demand in the economy. This higher level of aggregate demand creates jobs and higher wages for all workers.
  2. Alternatively, increased profits for firms may be reinvested into expanding output. This again leads to higher growth, wages and incomes for all.
  3. Lower income taxes increase the incentive to for people to work leading to higher productivity and economic growth.
  4. The Laffer curve suggests cutting tax can even cause an increase in tax revenues as the lower tax rates are offset by higher growth.

A study by NBER June 1997 Engen and Skinner conclude that:

“cutting marginal tax rates across the board by 5 percentage points and cutting average tax rates by 2.5 percentage points would increase the growth rate of U.S. GDP by 0.3 percentage points per year.”

Video on Trickle-down economics

Criticisms of trickle-down economics

I have a joke about trickle-down economics. Only 99% of you will get it.

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Many economists are sceptical of the belief in ‘the trickle-down’ effect. One reason, the wealthy have a higher marginal propensity to save, and also n recent years, wealth has been saved in off-shore accounts to avoid paying tax. Therefore, when the wealthy gain extra income, only a small percentage may filter through to low-income workers.

Also, some studies suggest that increased income inequality can lead to this inequality being solidified through educational opportunities, wealth accumulation and the growth of monopoly/monopsony power. Furthermore, increased inequality may lead to lower rates of economic growth.

Tax cuts have no clear impact on growth. In The Economic Consequences of Major Tax Cuts for the Rich (2020), by David Hope and Julian Limberg, the authors found tax cuts for the rich, had no statistical effect on economic growth. They looked particularly at the 1980s in UK and US, where significant taxes were cut.

“The results also show that economic performance, as measured by real GDP per capita and the unemployment rate, is not significantly affected by major tax cuts for the rich. The estimated effects for these variables are statistically indistinguishable from zero.” (LSE)

A report by the IMF (2015) found increasing income share of the poor increased economic growth, but increasing income share of the rich, led to lower growth.

“We find that increasing the income share of the poor and the middle class actually increases growth while a rising income share of the top 20 percent results in lower growth.”

Real GDP and Median wages in the US

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In the US, real GDP has grown faster than median wages since the early 1980s. In the 1980s, taxes were cut for high earners and there was a significant increase in inequality. Proponents of the Reagan tax cuts and supply-side economics argue it was worth it because everyone benefitted from rising GDP. However, the median wage, (which is the wage the middle-income earners actually receive has increased slower than real GDP, suggested not all the gains of the top 1% have trickled down to average workers.

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Inequality and lower growth. A recent report by the OECD found that since the start of the credit crisis in 2008, inequality has widened in many countries; however, this inequality has led to lower rates of economic growth not higher.

This graph from an OECD report suggests that inequality is responsible for lower GDP. The OECD estimates that the UK economy would have been more than 20% bigger had the gap between rich and poor not widened since the 1980s.

oecd-inequality Source: OECD Focus – Inequality and Growth 2014

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