Fiscal policy measures: changes in taxes

Government and the Macro‑economy – Fiscal Policy (Taxation)

1. Macroeconomic Aims (Cambridge IGCSE 0455)

• Economic growth – increase real GDP over time.
• Full‑employment – minimise cyclical unemployment.
• Price‑stability – keep inflation low and stable.
• Balance of payments equilibrium – avoid persistent deficits or surpluses.
• Redistribution of income – reduce inequality.
• Environmental sustainability – correct negative externalities (e.g., carbon taxes).

Fiscal policy – the combination of government spending and taxation – is the main tool used to move the economy towards these aims.

2. Definition and Objectives of Fiscal Policy

• Fiscal policy: the use of government spending (G) and taxation (T) to influence aggregate demand (AD) and, consequently, output, employment, price level and other macro‑economic goals.
• Four syllabus‑stated objectives (must be linked to a tax or spending measure):
  • Stabilisation – counteract recessions or inflation (e.g., a temporary tax cut to boost AD).
  • Redistribution – make the tax system more progressive (e.g., higher rates on high incomes).
  • Efficiency – correct market failures (e.g., excise duties on cigarettes, carbon tax).
  • Revenue generation – fund public services and keep the budget sustainable.

3. Why Governments Change Taxes

• To alter disposable income and therefore household consumption.
• To affect after‑tax profit, influencing business investment.
• To meet budgetary requirements – reduce a deficit or create a surplus.
• To achieve distributional goals – make the system more progressive or less regressive.
• To correct externalities (e.g., excise duties on alcohol, carbon taxes).
• To encourage or discourage specific behaviours (e.g., tax relief for research & development).

4. Types of Taxes

4.1 Direct vs Indirect

Classification	Definition	Typical IGCSE‑relevant examples
Direct	Levied on income, profit or wealth; paid straight to the government.	Income tax, corporation tax, capital gains tax, inheritance tax.
Indirect	Levied on the consumption of goods and services; collected by businesses and passed to the government.	Value‑added tax (VAT), excise duties, customs duties, sales tax.

4.2 Progressive, Regressive and Proportional (Flat)

Classification	Definition	IGCSE‑relevant example
Progressive	Tax rate rises as the taxable amount rises.	UK income‑tax bands – 20 % (basic), 40 % (higher), 45 % (additional).
Regressive	Tax rate falls as the taxable amount rises; low‑income earners pay a larger share.	Flat 5 % VAT on essential goods in some jurisdictions.
Proportional (Flat)	Same rate for all levels of income or value.	Flat corporate‑tax rate of 19 % in many countries.

4.3 Specific Tax Categories Required by the Syllabus

• Excise duties – levied on specific goods (e.g., tobacco, alcohol, fuel). Used to curb consumption of harmful products.
• Customs duties – taxes on imported goods; affect the balance of payments and protect domestic industries.
• Value‑added tax (VAT) – a consumption tax applied at each stage of production; usually a flat rate but can have reduced rates for essentials.
• Carbon / green taxes – designed to internalise environmental externalities and promote sustainability.

5. Government‑Budget Basics

• Government budget: annual statement of total revenue (R) and total spending (G).
• Budget deficit: G > R  →  Deficit = G – R
• Budget surplus: R > G  →  Surplus = R – G

Worked example: Revenue = £200 bn, Spending = £250 bn → Deficit = £50 bn.

6. How Tax Changes Affect the Macro‑economy

6.1 Disposable Income and Consumption

Disposable income (the income households actually have to spend):

$$Y_d = Y - T$$

• Tax increase → lower Y_d → lower consumption (C).
• Tax cut → higher Y_d → higher C.

6.2 Investment

• Higher corporation tax reduces after‑tax profit, discouraging investment in plant, equipment and R&D.
• Lower corporation tax raises after‑tax profit, encouraging investment (I).

6.3 Aggregate Demand (AD)

Expenditure approach:

$$AD = C + I + G + (X-M)$$

• Tax changes affect AD mainly via C and I.
• Direction of shift:
  • Tax increase → AD shifts left (down).
  • Tax cut → AD shifts right (up).

7. The Tax Multiplier

7.1 Derivation (step‑by‑step)

1. Consumption function: C = C_0 + MPC·Y_d.
2. Insert Y_d = Y - T: C = C_0 + MPC·(Y - T).
3. AD identity (assuming G, I, X‑M are autonomous): $$Y = C_0 + MPC(Y - T) + I + G + (X-M)$$
4. Collect Y‑terms: $$Y - MPC·Y = C_0 + I + G + (X-M) - MPC·T$$ $$Y(1 - MPC) = C_0 + I + G + (X-M) - MPC·T$$
5. Solve for Y and differentiate with respect to T: $$\frac{ΔY}{ΔT} = -\frac{MPC}{1 - MPC}$$

7.2 Formula and Interpretation

$$\text{Tax Multiplier} = -\frac{MPC}{1-MPC}$$

• Negative sign: a tax increase reduces output; a tax cut raises output.
• Magnitude depends on the marginal propensity to consume (MPC).
  Example: MPC = 0.8 → Tax multiplier = –4.0. A £1 bn tax cut raises equilibrium output by £4 bn (ceteris paribus).

8. Short‑run vs Long‑run Effects of Tax Changes

Variable	Short‑run impact (AO2)	Long‑run impact (AO2)
Aggregate Demand	Directly shifted via C and I (left after a tax rise, right after a tax cut).	May be partially offset by expectations, price‑level changes and supply‑side adjustments.
Real GDP (output)	Changes follow the tax multiplier.	Price‑level adjustments, crowding‑out and Laffer‑curve effects can dampen the initial gain.
Unemployment	Tax cut → higher AD → lower unemployment; tax rise → higher unemployment.	Economy tends back to the natural rate of unemployment as labour markets adjust.
Government revenue	Tax increase raises revenue immediately; tax cut may reduce revenue unless the output boost generates sufficient additional tax receipts.	Long‑run revenue is shaped by the Laffer‑curve relationship – very high rates can lower total revenue.
Budget balance	Tax rise widens surplus or narrows deficit; tax cut widens deficit or narrows surplus.	Multiplier‑induced output changes can offset the initial impact, moving the balance toward a new equilibrium.
Income distribution	Progressive tax cuts benefit lower‑income groups; regressive cuts tend to benefit higher earners.	Long‑run distribution also depends on labour‑market policies, education and skill formation.

9. Diagrams Required for Paper 2

• AD–AS diagram – show a leftward shift of AD after a tax increase and a rightward shift after a tax cut; label the initial and new equilibrium price level (P) and output (Y).
• Tax‑multiplier diagram – plot the consumption function before and after a change in T to illustrate the negative slope of ΔY/ΔT.
• Supply‑and‑demand diagram for a specific good – e.g., an excise duty on cigarettes shifts the supply curve upward (or the demand curve leftward), illustrating the efficiency effect.

Hand‑drawn diagrams are acceptable; ensure all axes, curves and shifts are clearly labelled.

10. Real‑World Examples of Tax Measures (IGCSE‑relevant)

• Income‑tax cut – United Kingdom (2022): basic rate reduced from 20 % to 19 % to stimulate consumer spending.
• Corporate‑tax increase – Germany (2021): statutory rate raised from 15 % to 25 % to fund pandemic‑related health expenditure.
• VAT reduction – India (2020): standard rate cut from 18 % to 12 % on selected goods to boost demand during COVID‑19.
• Excise duty on tobacco – Australia (2023): 10 % increase aimed at reducing smoking (efficiency/negative externality).
• Carbon tax – Sweden (2017 onward): tax on CO₂ emissions to encourage greener production and meet environmental targets.

11. Limitations and Unintended Consequences of Tax Changes

• Time lags – recognition, implementation and impact lags can delay the desired effect on AD.
• Crowding‑out – a tax cut that widens the deficit may force the government to borrow; higher interest rates can suppress private investment.
• Laffer‑curve effect – excessively high tax rates may discourage work and investment, reducing total revenue.
• Equity concerns – uniform tax cuts often benefit higher‑income groups more, potentially widening inequality.
• Efficiency losses – distortionary taxes can move consumption and production away from the most efficient allocation.
• Behavioural responses – tax avoidance, evasion, or shifting activity abroad can weaken the intended impact.
• International competitiveness – high corporate tax rates may drive firms to relocate, affecting the balance of payments.

12. Evaluation Checklist for Exam Answers (AO2)

1. Identify the measure (tax increase or decrease) and classify it (direct/indirect, progressive‑regressive‑proportional, excise/VAT/customs, green tax).
2. Explain the short‑run effect on disposable income, consumption, investment and AD using Y_d = Y – T and the tax‑multiplier.
3. State the sign and magnitude of the tax multiplier; interpret the negative sign.
4. Analyse short‑run outcomes for output, unemployment, government revenue and the budget balance.
5. Discuss likely long‑run adjustments (price‑level changes, crowding‑out, Laffer‑curve, labour‑market flexibility, external sector effects).
6. Evaluate against the four fiscal‑policy criteria: equity, efficiency, stabilisation and revenue generation. Mention any time‑lag issues.
7. Include a relevant, correctly labelled diagram (AD‑AS, taxed‑good market diagram, or tax‑multiplier graph).

13. Quick Summary

• Fiscal policy = government spending + taxation → influences AD.
• Tax changes affect disposable income → consumption → AD; they also affect after‑tax profit → investment.
• Tax multiplier = –MPC/(1‑MPC); a tax cut multiplies through the economy.
• Short‑run: clear AD shift, output and unemployment move with the multiplier.
• Long‑run: effects may be muted by price changes, crowding‑out, Laffer‑curve dynamics and structural factors.
• Always evaluate – consider equity, efficiency, stabilisation, revenue, environmental goals and time‑lag issues.