Cambridge IGCSE Economics 0455 – Supply‑Side Policy: Lower Direct Taxes
Government and the Macro‑economy – Supply‑Side Policy
Topic: Lower Direct Taxes
Supply‑side policies aim to increase the productive capacity of an economy. One of the most commonly used measures is the reduction of direct taxes on individuals and firms. By lowering the cost of labour and capital, the government hopes to encourage greater work effort, investment and entrepreneurship, thereby shifting the long‑run aggregate supply (LRAS) curve to the right.
Key Concepts
Direct taxes are levied directly on income, profits or wealth (e.g., income tax, corporation tax, capital gains tax).
Lowering direct taxes reduces the marginal tax rate faced by households and firms.
In theory, a lower marginal tax rate raises the after‑tax return to work or invest, increasing the incentive to supply labour and capital.
How Lower Direct Taxes Work
Increase in disposable income – Households keep a larger share of their earnings, which can lead to higher consumption and savings.
Higher after‑tax profit – Firms retain more of their earnings, improving the profitability of new investment projects.
Improved labour market incentives – A lower income‑tax rate raises the net wage, encouraging greater labour‑force participation and longer working hours.
Enhanced capital formation – Lower corporation tax and capital‑gains tax increase the net return on capital, stimulating investment in plant, equipment and research.
Expected Economic Effects
Variable
Short‑run effect
Long‑run effect
Aggregate Supply (AS)
Small upward shift if firms increase output quickly.
Significant rightward shift of LRAS as investment raises productive capacity.
Aggregate Demand (AD)
Increase due to higher disposable income and consumption.
Potential further increase if higher investment raises income.
Employment
Modest rise as firms hire to meet higher demand.
Substantial rise as expanded capacity requires more labour.
Price level
Possible upward pressure if AD rises faster than AS.
Neutral or downward pressure if LRAS expands sufficiently.
Illustrative Diagram
Suggested diagram: LRAS shifting rightward due to lower direct taxes, with a modest AD shift upward. Label the initial equilibrium (E₀) and the new long‑run equilibrium (E₁).
Potential Advantages
Encourages work effort and reduces unemployment.
Stimulates private investment and capital formation.
Can improve competitiveness by lowering production costs.
May increase tax compliance if rates are perceived as fair.
Potential Disadvantages and Limitations
Reduces government revenue in the short term, possibly widening fiscal deficits.
Effectiveness depends on the existing tax rate; large cuts are needed if rates are already low.
May lead to higher income inequality if benefits accrue mainly to higher‑income earners.
Supply‑side effects can be slow to materialise; the economy may experience a lag before output rises.
Key Evaluation Points
Size of the tax cut – Small reductions may have negligible impact, whereas large cuts risk fiscal instability.
Economic context – In a recession with idle resources, lower taxes can boost output; in an overheating economy they may fuel inflation.
Complementary policies – Combining tax cuts with investment incentives (e.g., accelerated depreciation) can enhance effectiveness.
Revenue neutrality – Governments may offset tax cuts with spending cuts or other revenue measures to maintain fiscal balance.
Summary Formula
The change in after‑tax income (\$\Delta Y_{after}\$) can be expressed as:
\$\$
\Delta Y_{after} = Y \times \Delta (1 - t)
\$\$
where \$Y\$ is pre‑tax income and \$t\$ is the marginal tax rate. A reduction in \$t\$ raises \$\Delta Y_{after}\$, which can be allocated to consumption (\$C\$) or savings (\$S\$), influencing aggregate demand and investment respectively.