Fiscal policy measures: changes in taxes

Government and the Macro‑economy – Fiscal Policy

Objective: Understand Fiscal Policy Measures – Changes in Taxes

Fiscal policy is the use of government spending and taxation to influence the level of economic activity. This note focuses on how changes in taxes affect the macro‑economy.

1. Why Governments Change Taxes

• Stabilisation: To manage aggregate demand (AD) during recessions or inflationary periods.
• Redistribution: To reduce income inequality by shifting the tax burden.
• Efficiency: To correct market failures (e.g., taxes on negative externalities).
• Revenue Generation: To fund public services and maintain a sustainable budget balance.

2. Types of Tax Changes

1. Tax Increase (Tax Rise): Raises the amount of tax payable.
2. Tax Decrease (Tax Cut): Lowers the amount of tax payable.
3. Direct Taxes: Levied directly on income, profits, or wealth (e.g., income tax, corporation tax).
4. Indirect Taxes: Levied on the consumption of goods and services (e.g., value‑added tax (VAT), excise duties).

3. Theoretical Impact of Tax Changes on Aggregate Demand

The effect of a tax change on AD can be expressed using the expenditure approach:

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

Where:

• \$C\$ = Consumption
• \$I\$ = Investment
• \$G\$ = Government spending
• \$X-M\$ = Net exports

Changes in taxes primarily affect \$C\$ and \$I\$:

• Consumption: Disposable income \$Yd = Y - T\$ (where \$T\$ is tax). A tax increase reduces \$Yd\$, lowering \$C\$; a tax cut does the opposite.
• Investment: Higher corporate taxes reduce after‑tax profit, discouraging investment; lower corporate taxes have the reverse effect.

4. The Tax Multiplier

The tax multiplier shows the change in equilibrium output (\$\Delta Y\$) resulting from a change in taxes (\$\Delta T\$). It is derived from the marginal propensity to consume (MPC):

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

Because the multiplier is negative, a tax increase reduces output, while a tax cut raises output.

5. Short‑run vs Long‑run Effects

6. Examples of Tax Measures

• Income Tax Cut (UK, 2022): Reduced basic‑rate tax from 20 % to 19 % to stimulate consumer spending.
• Corporate Tax Increase (Germany, 2021): Raised the statutory rate from 15 % to 25 % to fund pandemic‑related health spending.
• VAT Reduction (India, 2020): Lowered the standard rate from 18 % to 12 % on selected goods to boost demand during CO \cdot ID‑19.

7. Potential Limitations and Unintended Consequences

• Time Lags: Recognition, implementation, and impact lags can delay the desired effect.
• Crowding‑out: If a tax cut leads to higher deficits, future borrowing may raise interest rates, reducing private investment.
• Laffer Curve: Excessively high tax rates may reduce total revenue by discouraging work and investment.
• Equity Concerns: Uniform tax cuts may benefit higher‑income groups more, widening inequality.

8. Summary Checklist for Exam Questions

1. Identify the type of tax change (increase/decrease, direct/indirect).
2. Explain the short‑run effect on disposable income, consumption, investment and AD.
3. State the tax multiplier formula and interpret its sign.
4. Discuss possible short‑run and long‑run outcomes for output, unemployment and government revenue.
5. Consider equity, efficiency and any likely time lags.