IGCSE Economics 0455 – Supply‑Side Policy: Improving Incentives to Work and Invest
Government and the Macro‑economy – Supply‑Side Policy
Objective of this Lesson
To understand the range of supply‑side policy measures that aim to improve incentives for households to work and for firms to invest, and to evaluate their likely impact on economic growth, unemployment and inflation.
Why Focus on Incentives?
Supply‑side policies target the determinants of aggregate supply (AS). By making work and investment more attractive, the economy can increase its productive capacity, shift the long‑run aggregate supply (LRAS) curve to the right and achieve sustainable growth.
Improving Incentives to Work
Lower Income Tax Rates – Reduces the marginal tax rate on labour income, increasing the net wage received by workers.
Welfare‑to‑Work Programs – Conditional benefits that require recipients to seek employment or undertake training.
Education and Skills Development – Expanding vocational training and apprenticeships raises the productivity of workers, making work more rewarding.
Minimum Wage Adjustments – Setting a floor that reflects productivity can raise the incentive to supply labour, but if set too high it may discourage hiring.
Childcare Subsidies – Reduces the opportunity cost of work for parents, especially women.
Improving Incentives to Invest
Corporate Tax Cuts – Lowering the statutory corporate tax rate raises after‑tax profits, encouraging firms to expand capital stock.
Investment Allowances / Accelerated Depreciation – Allows firms to write off a larger proportion of investment costs in the first year, reducing the effective cost of capital.
R&D Tax Credits – Grants tax relief for expenditure on research and development, stimulating innovation.
Deregulation and Reducing Red Tape – Simplifies planning permissions and licensing, lowering the time and cost of starting or expanding projects.
Privatisation of State‑Owned Enterprises – Transfers assets to the private sector, where profit motives increase efficiency and investment.
Improved Infrastructure – Investment in transport, energy and digital networks reduces transaction costs for businesses.
Table: Supply‑Side Measures – Objectives and Expected Impact
Measure
Target Group
Primary Objective
Expected Macro‑economic Impact
Lower Income Tax Rates
Households (workers)
Increase net wages → higher labour supply
Shift LRAS right; lower unemployment; possible increase in inflation if demand rises faster
Welfare‑to‑Work
Unemployed benefit‑receivers
Encourage job‑search and training
Higher employment; reduced government spending on benefits
Corporate Tax Cuts
Firms
Raise after‑tax profitability → more investment
Increase capital formation; shift LRAS right; potential short‑run fiscal deficit
Accelerated Depreciation
Firms
Reduce effective cost of capital
Boost in equipment purchases; higher productivity; LRAS rightward shift
R&D Tax Credits
Innovative firms
Stimulate technological progress
Long‑run productivity gains; shift LRAS right
Deregulation
All businesses
Lower administrative costs and entry barriers
More firms entering market; competition; LRAS right
How the Measures Work – Simple Model
Consider the labour supply function \$L_s = f(w(1-t))\$, where \$w\$ is the gross wage and \$t\$ is the marginal tax rate. A reduction in \$t\$ raises the after‑tax wage \$w(1-t)\$, shifting the labour supply curve outward.
For investment, the user cost of capital \$c\$ can be expressed as:
\$c = r + \delta - \frac{\taui}{1-\taui}\$
where \$r\$ is the real interest rate, \$\delta\$ is depreciation, and \$\taui\$ is the tax allowance rate. Increasing \$\taui\$ (e.g., through accelerated depreciation) lowers \$c\$, encouraging firms to increase the capital stock \$K\$.
Advantages and Disadvantages
Advantages
Potential for sustainable, long‑run growth.
Can reduce fiscal burdens if higher growth expands the tax base.
Improves competitiveness of the economy.
Disadvantages
Short‑run fiscal deficit if tax cuts are not offset.
Risk of widening income inequality if benefits accrue mainly to high‑skill workers and large firms.
Some measures (e.g., privatisation) may lead to job losses in the transition period.
Suggested Diagram
Suggested diagram: LRAS shifts rightward due to supply‑side measures that improve incentives to work and invest. Show initial equilibrium (P₁, Y₁) moving to a new equilibrium (P₂, Y₂) with lower unemployment and potentially higher price level.
Key Points to Remember
Supply‑side policies aim at the determinants of potential output, not just short‑run demand.
Improving incentives to work primarily affects the labour market; incentives to invest affect the capital market.
Policy effectiveness depends on the existing tax structure, the flexibility of the labour market, and the level of existing public investment.
Evaluation must consider both macro‑economic outcomes and distributional effects.
Potential Exam Questions
Explain how a reduction in the marginal income tax rate can increase the level of employment in an economy.
Discuss the likely impact of accelerated depreciation allowances on a country's long‑run aggregate supply.
Evaluate the advantages and disadvantages of using welfare‑to‑work programmes as a supply‑side policy.