effects of changes in taxes on business profit

6.1.2 – Effects of Government Policy: Changes in Taxes on Business Profit

1. Why taxes matter to businesses

• Taxes are compulsory payments to the government.
• They are a cost that reduces the amount of profit a business can retain.
• Any change in the rate, base or existence of a tax therefore has a direct impact on profitability and on strategic decisions.

2. Government economic objectives and the tax tools used to achieve them

In the IGCSE syllabus tax policy is a key instrument for four main macro‑economic objectives. The table below shows which type of tax (or tax‑related measure) is normally used to support each objective.

3. Types of taxes that affect profit

• Corporation tax – charged on taxable profit (profit before tax after allowable deductions).
• Value‑Added Tax (VAT) / Sales tax – added to the selling price; the business collects it on behalf of the government and passes it on.
• Payroll taxes – contributions such as National Insurance (UK) or Social Security (US) paid by the employer on employee wages. They increase the cost of labour and therefore affect the employment decision.
• Excise duties – specific taxes on particular goods (alcohol, tobacco, fuel, etc.).
• Property tax – levied on the value of business premises or land.

4. How a change in tax rates influences profit

The basic profit calculation used in IGCSE questions is:

Profit before tax = Revenue – Operating costs (excluding tax)

Tax expense = Tax rate × (Profit before tax)

Profit after tax = Profit before tax – Tax expense

Note: The profit before tax shown here is a simplified figure. In exam questions you may be asked to adjust it for allowable deductions such as depreciation or capital allowances before applying the tax rate.

Consequences of a tax change:

1. Increase in tax rate – tax expense rises → profit after tax falls (ceteris paribus).
2. Decrease in tax rate – tax expense falls → profit after tax rises.
3. Introduction of a new tax – adds a new cost line → profit after tax falls.
4. Removal of a tax – eliminates a cost line → profit after tax rises.

5. Numerical example (corporation tax)

Current profit after tax:

Tax expense = 20 % × 150,000 = 30,000
Profit after tax = 150,000 – 30,000 = 120,000

If the corporation‑tax rate rises to 25 %:

Tax expense = 25 % × 150,000 = 37,500
Profit after tax = 150,000 – 37,500 = 112,500
Result: Profit falls by £7,500 (a 6.25 % reduction).

6. Tax incentives, reliefs, holidays and credits – IGCSE‑level examples

• Tax incentives – e.g., a 10 % reduction in corporation tax for companies that invest in renewable‑energy equipment.
• Tax reliefs (allowances) – Capital allowances: a business can deduct a fixed percentage (often 20 %) of the cost of new plant and machinery from its taxable profit each year.
  Example: A firm buys machinery for £100,000. In the first year it can claim a 20 % allowance (£20,000), reducing taxable profit from £150,000 to £130,000. At a 20 % tax rate the tax saving is £4,000.
• Tax holidays – a new manufacturing zone may be offered a 5‑year exemption from corporation tax to attract investment.
• Tax credits – e.g., an “employment‑creation credit” of £500 per new full‑time employee that is deducted directly from the tax liability.

These measures are deliberately designed to encourage activities that support the government’s macro‑economic objectives.

7. Wider business implications of tax changes

The table links typical business responses to a tax increase with the relevant government objective.

8. Interaction with other external influences

• Environmental / ethical considerations – Higher excise duties on polluting products encourage firms to adopt greener processes, giving early adopters a competitive advantage.
• International factors – Different tax regimes affect export competitiveness and may lead firms to offshore production to benefit from lower corporation‑tax rates.
• Legal & regulatory environment – New tax legislation often brings additional reporting requirements that interact with health‑and‑safety, consumer‑protection or accounting regulations.

9. Exam tip – answering a question on tax effects (PEEL)

1. Point: State the likely effect of the tax change on profit (e.g., “An increase in corporation tax will reduce profit after tax”).
2. Explain: Show the reasoning – higher tax rate → larger tax expense → lower profit.
3. Example: Provide a short numerical illustration similar to the one in section 5.
4. Link: Connect the profit change to wider business decisions (pricing, investment, location, etc.) and to the relevant government objective.

10. Suggested diagram – Flowchart of a tax increase

11. Summary

• Taxes are a mandatory cost that directly reduces profit.
• Increasing tax rates or adding new taxes lowers profit; decreasing rates or removing taxes raises profit.
• Governments use specific tax tools to pursue the four macro‑economic objectives: growth, full employment, price stability, and balance‑of‑payments.
• Businesses react to tax changes through pricing, cost‑cutting, relocation, investment decisions, profit‑sharing and compliance measures.
• Tax incentives, reliefs, holidays and credits can offset the negative impact of higher taxes and encourage behaviours that match government goals.
• Understanding the link between tax policy, profit, and strategic decisions is essential for both exam success and real‑world business planning.