effects of changes in taxes on people’s income

6.1.2 Effects of Government Policy – Changes in Taxes on People’s Income

1. Why governments use tax policy

Taxation is a principal tool for achieving the three core macro‑economic objectives set out in the Cambridge IGCSE Business Studies syllabus:

• Economic growth – raising revenue to invest in infrastructure, education, research and other productivity‑enhancing projects.
• Full employment – funding public‑sector jobs, training schemes and incentives that encourage private‑sector hiring.
• Price stability – using specific taxes (e.g., on fuel, alcohol, sugary drinks) to curb excess demand and help control inflation.

Consequently, any change in tax rates or the introduction of a new tax is deliberately designed to influence disposable income, consumer spending, business profitability and, ultimately, the overall economy.

2. What is a tax?

A tax is a compulsory financial charge or levy imposed by a government on individuals, businesses or other entities. The revenue collected funds public services such as education, health, transport, defence and social welfare.

3. Key types of taxes that affect personal income

• Income Tax – charged on earnings from employment, self‑employment or investments.
• National Insurance / Social Security Contributions – deducted from wages to fund state pensions and welfare benefits.
• Value‑Added Tax (VAT) – an indirect tax on goods and services; it reduces purchasing power rather than directly reducing earnings.
• Capital Gains Tax – charged on profit from the sale of assets such as property or shares.

4. How taxes affect disposable (net) income

Disposable income is the amount of money an individual has left after tax has been deducted from gross (pre‑tax) income.

Basic relationship:

$$\text{Net Income} = \text{Gross Income} - \text{Tax Paid}$$

where

$$\text{Tax Paid} = \text{Gross Income} \times \text{Tax Rate}$$

Illustrative example – change in income‑tax rate

Gross Income (£)	Tax Rate (%)	Tax Paid (£)	Net Income (£)
30,000	20	6,000	24,000
30,000	25	7,500	22,500

When the tax rate rises from 20 % to 25 %, tax paid increases by £1,500 and net income falls by the same amount.

5. Broader effects of higher taxes on individuals

• Reduced consumer spending – lower disposable income means less money for non‑essential goods and services, which can slow economic growth.
• Changes in saving behaviour – households may save less (reducing future financial security) or, conversely, increase precautionary savings if they anticipate further tax rises.
• Work‑life decisions – higher marginal tax rates can discourage overtime, extra work, or entrepreneurship, limiting income‑growth opportunities.
• Impact on low‑income households – because a larger proportion of their earnings is spent on necessities, a tax increase can have a proportionally bigger effect on their standard of living.

6. Impact of tax changes on business activity (Syllabus 6.1.2)

6.1 Direct tax effects on businesses

• Corporate tax – higher rates reduce after‑tax profit, which may lead to lower dividend payouts, reduced reinvestment and slower expansion.
• VAT and sales taxes – increase the price of final goods; businesses may face reduced demand or be forced to absorb part of the tax, cutting margins.
• Payroll taxes (National Insurance, Social Security) – raise the cost of labour, encouraging firms to automate, outsource or hire fewer staff.
• Cash‑flow considerations – larger tax payments can tighten cash flow, making it harder for small firms to finance inventory, equipment or short‑term borrowing.
• Investment decisions – higher taxes on profits or capital gains can make new projects appear less attractive, slowing capital formation.

6.2 What this means for the business?

Tax Effect	Decision/Behaviour Likely to Change
Higher corporate tax	Reduced net profit → lower dividend payouts; may postpone or cancel investment in new plant or machinery.
Higher VAT	Higher selling price → possible fall in sales volume; firm may absorb part of the tax to remain competitive, squeezing margins.
Higher payroll taxes	Increased labour cost → greater use of automation, part‑time contracts or outsourcing; slower recruitment.
Cash‑flow pressure from larger tax bills	Greater reliance on short‑term credit; may delay stock purchases or defer maintenance.
Higher capital‑gains tax	Owners less willing to sell assets or invest in growth‑oriented projects; preference for low‑risk, low‑return activities.

6.3 Numerical case‑study – corporate‑tax increase

Background: A small manufacturing firm makes a profit before tax (PBT) of £200,000. The corporate‑tax rate is increased from 20 % to 25 %.

Scenario	Corporate Tax Rate	Tax Payable (£)	Profit After Tax (PAT) (£)	Impact on Investment Decision
Current	20 %	40,000	160,000	Enough retained earnings to fund a £50,000 equipment upgrade.
After increase	25 %	50,000	150,000	Reduced PAT makes the upgrade marginal; firm may postpone or seek external finance.

This simple illustration shows how a 5 % rise in corporate tax cuts net profit by £10,000, potentially altering a firm’s capital‑investment plan.

7. Interaction with other government policies (Syllabus 6.1.2)

7.1 Changes in government spending

Tax changes are rarely isolated; they are often paired with adjustments to public expenditure.

Policy Change	Likely impact on business	Likely impact on consumer demand	Evaluation (AO4)
Higher taxes + increased infrastructure spending	Higher costs, but new roads/ports improve logistics → possible offset to profit loss.	Higher taxes reduce disposable income; infrastructure projects create jobs → mixed effect.	Net effect depends on the size of the spending multiplier relative to the tax‑rate increase.
Higher taxes + austerity (reduced public spending)	Higher costs + weaker demand for business services → likely contraction.	Reduced disposable income + fewer public‑sector jobs → clear fall in consumer demand.	Most likely to depress aggregate demand and slow growth.

7.2 Changes in interest rates (monetary policy)

Although set by the central bank, interest‑rate moves interact with tax policy.

Monetary‑policy move	Interaction with a tax rise	Evaluation
Higher interest rates	Borrowing costs rise → households have less disposable income; businesses face higher finance costs, amplifying the contractionary effect of a tax increase.	Combined effect is strongly contractionary – likely to reduce output and employment.
Lower interest rates	Cheaper credit can partially offset lower disposable income, encouraging spending and investment despite higher taxes.	Mitigates the negative impact of a tax rise, but does not fully neutralise it.

8. Stakeholder objectives & potential conflicts

• Government – aims to raise revenue, achieve macro‑economic objectives and promote fairness.
• Business owners/managers – seek higher profits, cash flow stability, low operating costs and a predictable tax environment.
• Employees – want stable wages, job security and affordable living costs.
• Consumers – desire low prices and sufficient disposable income to maintain their standard of living.

Potential conflicts:

• Higher taxes increase government revenue but can reduce business profitability, leading to lower investment and possible job cuts – a clash between government and business/employee objectives.
• Progressive tax systems improve income‑distribution (government objective) but may discourage high‑earners from working extra hours or starting new ventures (business/employee objective).
• VAT hikes protect price‑stability goals but raise the cost of living for consumers, especially low‑income households.

9. Potential positive outcomes of tax increases

• Increased revenue can fund public services that improve quality of life (healthcare, education, transport).
• Progressive tax systems help reduce income inequality by taxing higher earners at higher rates.
• Better infrastructure and social safety nets create a more stable business environment, indirectly supporting employment and wages.

10. Key points to remember

1. Disposable (net) income = Gross income – Tax paid.
2. Higher tax rates reduce net income, which can lower consumer spending and saving.
3. The impact of a tax change varies with income level; low‑income earners feel a larger relative effect.
4. Tax policy is used to achieve the three macro‑economic objectives – growth, full employment and price stability.
5. Businesses are affected through corporate tax, VAT, payroll taxes, cash‑flow constraints and investment decisions; each effect links to a specific managerial choice (pricing, staffing, capital spending).
6. Tax changes interact with government‑spending and interest‑rate policy; the net impact depends on the size and direction of those accompanying measures.
7. Stakeholder objectives can conflict – governments seek revenue, while businesses and households seek higher after‑tax income and lower costs.

11. Practice questions

1. A person earns £45,000 per year. If the income‑tax rate is increased from 22 % to 28 %, calculate the change in their net annual income.
2. Explain two ways in which a rise in corporate tax could affect a small business owner’s decision to expand.
3. Discuss how a progressive tax system can help reduce income inequality, providing one advantage and one possible disadvantage.
4. Explain how a simultaneous increase in income tax and a cut in government spending might affect overall consumer demand.
5. Describe how a rise in interest rates could amplify the effect of a higher income‑tax rate on household disposable income.
6. Using the case‑study in 6.3, evaluate whether the £10,000 reduction in profit after tax is likely to stop the firm’s equipment upgrade, considering possible external financing.