Impact of taxation on consumers, workers, producers/firms, the government and the economy

Government and the Macro‑economy – Fiscal Policy

1. Definition of fiscal policy (Syllabus 4.2.1)

Fiscal policy is the use of government spending and taxation to influence the level of economic activity and to achieve macro‑economic objectives such as economic growth, low unemployment, price stability and a sustainable balance of payments.

2. Why governments tax (Syllabus 4.2.1)

• Raise revenue – to fund public services (health, education, defence, infrastructure).
• Redistribute income – progressive taxes take more from high‑income households and fund benefits for low‑income households.
• Discourage demerit goods – e.g., excise duty on cigarettes.
• Reduce imports – import duties/tariffs raise the price of foreign goods.
• Influence demand – taxes can curb excessive consumption (e.g., sugary‑drink levy).
• Promote environmental sustainability – carbon tax or green levy internalises the cost of pollution.

3. Classifications of tax (Syllabus 4.2.2)

3.1 By type (progressive, regressive, proportional)

3.2 By incidence (who legally pays)

4. Impact of taxation on the four main groups (Syllabus 4.2.3)

4.1 Consumers

• Higher market price → lower real disposable income.
• Consumer surplus falls – shown by the area between the demand curve and the price line up to the new (lower) quantity.
• Possible substitution to untaxed or lower‑taxed goods.

4.2 Workers

• Income tax and payroll tax reduce the net wage received.
• If the substitution effect dominates, labour‑supply may fall (workers supply less labour at a lower net wage).
• Higher employer‑paid taxes increase the cost of hiring, potentially reducing employment.

4.3 Producers / Firms

• Taxes on profits or on inputs raise production costs.
• Supply curve shifts leftward; firms need a higher price to supply each quantity.
• Profit margins shrink unless the firm can pass the tax onto consumers (price‑pass‑through).
• Higher tax burden can deter investment, affecting long‑run growth.

4.4 Government

• Revenue – funds public‑good provision, transfer payments and debt repayment.
• Budget balance – higher tax receipts can create a surplus or reduce a deficit; a deficit must be financed by borrowing, influencing the national debt.
• Redistribution – progressive taxes combined with welfare benefits reduce inequality.
• Distortionary effects – taxes may create dead‑weight loss, encourage tax evasion or push activity into the informal sector.

5. Fiscal‑policy tools – tax and spending (Syllabus 4.2.4‑4.2.5)

• Taxation and government spending are the two main fiscal‑policy instruments.
• Counter‑cyclical fiscal policy:
  • Recession – cut taxes and/or increase spending → disposable income rises → aggregate‑demand (AD) curve shifts right.
  • Inflationary boom – raise taxes and/or cut spending → disposable income falls → AD shifts left.
• These shifts are illustrated in the diagram below.

6. Tax incidence – who really bears the burden? (Syllabus 4.2.6)

The division of a tax’s burden between consumers and producers depends on the relative price‑elasticities of demand and supply.

6.1 Dead‑weight loss (DWL) – efficiency loss (Syllabus 4.2.6‑4.2.7)

Any tax reduces the quantity traded below the free‑market level, creating a loss of economic efficiency.

For a per‑unit tax t on a market with linear demand P = a – bQ and supply P = c + dQ, the dead‑weight loss is:

DWL = ½ × t × ΔQ

where ΔQ is the fall in equilibrium quantity caused by the tax.

7. Summary table (Syllabus 4.2.7)

8. Suggested revision diagrams

• Supply‑and‑demand with a per‑unit tax – show the leftward shift of the supply curve, the new consumer price, the price received by producers, and the dead‑weight‑loss triangle.
• Tax‑incidence diagram – illustrate how a more elastic demand or supply changes the division of the tax burden.
• Aggregate‑demand shift diagram – demonstrate how a tax cut moves AD right and a tax increase moves AD left (counter‑cyclical fiscal policy).

9. Exam‑style checklist (key points to remember)

• Tax incidence is determined by the relative price‑elasticities of demand and supply, not by who legally pays the tax.
• All taxes create a dead‑weight loss unless they correct a market failure (e.g., a carbon tax).
• Revenue can be used for public‑good provision, redistribution and debt reduction – these benefits may partially offset the efficiency loss.
• Progressive taxes reduce inequality; regressive taxes can increase it.
• Counter‑cyclical fiscal policy uses tax cuts or increases to shift the AD curve and stabilise the economy.
• Excessive or poorly designed taxes can discourage work, saving and investment, slowing long‑run growth.