In a bold move, the UK government have announced a one year cut in VAT from 17.5% to 15%. To partly finance this, they have increased the higher rate of income tax from 40% to 45%. The argument is that a cut in VAT will increase consumer spending; it will discourage people from delaying purchases until after the recession.
However, the increase in the higher rate of income tax (this is a marginal tax rate charged on earnings above a threshold close to £39,000) will not reduce spending significantly. It is argued that higher income earners have a lower marginal propensity to consume. Also the tax rise will only affect 4 million taxpayers
In a way the government is trying to maintain a low savings ratio.
In this post, I examine whether a rise in the savings ratio is beneficial
Readers Question: would you explain the fiscal policies that would be adcocated during a recession and during a period of inflation by those who (a) wish to expand the public sector and (b) wish to contract the size of government.
(a) To expand the public sector, the government would increase spending. For example, spending money on public works schemes such as building roads. This higher spending would be financed by higher levels of government borrowing.
b) To contract the size of the government, the government would cut taxes. E.g. cutting VAT by 17.5% or cutting income tax. This tax cut would also be financed by borrowing. But, it does not involve increasing the government’s spending as a % of GDP.