Cambridge IGCSE Economics 0455 – Supply‑Side Policy: Lower Direct Taxes

Supply‑Side Policy – Full List (Section 4.4)

Supply‑side measures are actions that increase an economy’s productive capacity (i.e. shift LRAS to the right). The syllabus recognises six main policies:

1. Education and training
2. Infrastructure spending
3. Labour‑market reforms
4. Lower direct taxes
5. Deregulation
6. Incentives to work and invest (e.g., accelerated depreciation, tax reliefs)

“Privatisation” is listed elsewhere in the syllabus under the mixed‑economy topic and is not counted among the six supply‑side measures.

1. Definition and Rationale (AO1)

• Supply‑side policy: Government actions that increase the economy’s productive capacity, shifting the LRAS curve to the right.
• Direct taxes: Taxes on income, profits or wealth (income tax, corporation tax, capital‑gains tax). Reducing these taxes is a supply‑side measure because it lowers the cost of labour and capital.
• Lowering the marginal tax rate raises the after‑tax return to work, saving and investment, which should:
  • Encourage greater labour‑force participation and longer working hours.
  • Stimulate private investment in plant, equipment and research.
  • Promote entrepreneurial activity.
• Ultimate aim: a right‑ward shift of LRAS → higher potential output and long‑run economic growth.

2. Mechanism – How Lower Direct Taxes Work (AO1)

1. Higher disposable income for households – a cut in income tax raises net wages, boosting consumption (C) and saving (S).
2. Higher after‑tax profit for firms – a reduction in corporation tax or capital‑gains tax raises net returns, making more projects financially viable.
3. Improved labour‑market incentives – lower marginal tax rates increase the net wage, encouraging people to enter or stay in work and to work extra hours.
4. Enhanced capital formation – lower tax on profits and capital gains raises the after‑tax rate of return on investment, stimulating demand for capital goods.

3. Diagram – AD–SRAS–LRAS Framework (AO2)

Insert a labelled sketch showing:

• Initial equilibrium at point E₀ where AD₀ meets SRAS₀ and LRAS₀.
• Short‑run shifts: a modest right‑ward shift of AD to AD₁ and a slight upward shift of SRAS to SRAS₁.
• Long‑run shift: a larger right‑ward shift of LRAS to LRAS₁.
• New long‑run equilibrium at point E₁ with higher real GDP; the price‑level effect depends on the relative size of the shifts.

4. Expected Economic Effects

Variable	Short‑run effect	Long‑run effect
SRAS	Small upward shift (firms use spare capacity, overtime).	Significant rightward shift of LRAS as new plant, equipment and skills expand capacity.
AD	Increases because higher disposable income raises consumption and higher profits raise investment.	May rise further if the larger output generates additional income and thus more consumption.
Employment	Modest rise as firms hire to meet the small SRAS increase.	Substantial rise as expanded capacity requires more labour.
Price level	Possible upward pressure if AD rises faster than SRAS.	Neutral or downward pressure if LRAS expands enough to meet higher AD.
Fiscal deficit / tax revenue	Revenue falls immediately, potentially widening the deficit.	Deficit may narrow if higher growth raises tax receipts in the longer term.

5. Potential Advantages (AO2)

• Increases incentives to work, save and invest – can reduce unemployment.
• Stimulates private‑sector capital formation, enhancing future growth.
• Lowers production costs, improving international competitiveness.
• May improve tax compliance if rates are perceived as fair.
• Can be implemented quickly compared with large‑scale infrastructure projects.

6. Potential Disadvantages & Limitations (AO2)

• Revenue loss: Immediate reduction in tax revenue can widen the fiscal deficit unless offset by spending cuts or other taxes.
• Size matters: Small cuts have limited impact, especially when existing rates are already low.
• Distributional impact: Direct‑tax cuts often benefit higher‑income households and large firms more than low‑income earners, potentially widening inequality.
• Time lags: The supply‑side response (new investment, skill acquisition) can take months or years to materialise.
• Inflation risk: In an economy close to full capacity, the AD boost may outpace supply, generating demand‑pull inflation.
• External constraints: International agreements or fiscal‑rule limits may restrict the magnitude of tax cuts.

7. Evaluation Criteria (AO2 – aligned with syllabus wording)

1. Effectiveness: How much does the tax cut actually raise output and employment?
2. Distributional impact: Who benefits – high‑income earners/firms or low‑income households?
3. Time‑lag: How long before the supply‑side effects (new plant, skills) appear?
4. Inflation risk: Is the economy near full capacity, making price‑level rises likely?
5. Fiscal sustainability: Does the loss in revenue threaten the deficit or debt levels?
6. Magnitude of the cut: Large cuts may boost growth but jeopardise fiscal balance; small cuts are fiscally safe but may be ineffective.
7. Economic context: More effective in a recession with idle resources; less so in an overheating economy.
8. Complementary policies: Pairing tax cuts with investment incentives (e.g., accelerated depreciation) or infrastructure spending can accelerate the LRAS shift.
9. Revenue‑neutral approach: Offsetting the tax cut by cutting non‑productive spending or widening other taxes preserves the fiscal balance.
10. Expectations & confidence: If businesses expect future tax rises, they may save rather than invest, reducing the policy’s impact.

8. Formula for After‑Tax Income

The change in after‑tax income resulting from a change in the marginal tax rate is:

\[ \Delta Y_{\text{after}} = Y \times \Delta (1 - t) \]

where:

• \(Y\) = pre‑tax income (or profit),
• \(t\) = marginal tax rate,
• \(\Delta (1 - t)\) = change in the after‑tax proportion.

Worked numeric example

Suppose a household earns £30 000 a year and the marginal income‑tax rate falls from 30 % to 25 %.

\[ \begin{aligned} \text{Before cut: } & Y_{\text{after}} = £30\,000 \times (1-0.30) = £21\,000 \\ \text{After cut: } & Y_{\text{after}} = £30\,000 \times (1-0.25) = £22\,500 \\ \Delta Y_{\text{after}} &= £22\,500 - £21\,000 = £1\,500 \end{aligned} \]

The extra £1 500 can be spent (raising AD) or saved (potentially financing future investment that shifts LRAS).

9. Summary

Lowering direct taxes is a classic supply‑side measure aimed at increasing the economy’s productive capacity. In the short run it raises disposable income and profits, shifting AD (and possibly SRAS) upwards. In the long run the higher incentives to work and invest shift LRAS to the right, delivering higher potential output. The policy’s success depends on the size of the cut, the state of the economy, complementary measures, and its impact on the fiscal deficit and income distribution.