Fiscal Policy: Tax Rates

After looking at the Bank of England’s functions, it is time to look at fiscal policy – the demand-side policies implemented by the government to try to meet certain macroeconomic objectives. Firstly, we begin with tax rates, and how they can be manipulated to combat inflation, stimulate growth and meet many other macroeconomic objectives.

Taxes are essentially costs of consuming/producing goods and services that a government can implement to raise revenue, discourage the consumption/production of that good or service, or both. There are two main types of tax – direct and indirect. Direct taxes are incident on the individual/organisation directly and mainly taxes cashflow – examples of direct taxes include income tax, corporation tax and council tax. These are a percentage of the cashflow being taxed, and so affect everyone the same. Indirect taxes are incident on the good/service being consumed, and so the tax is passed on to the consumer – how much of it is passed on depends on the producer and PED. These do not affect everyone equally – VAT on a good is the same for people on benefits and billionaires, and so an increase in VAT (and indirect taxes in general) can affect poorer households disproportionately more.

If the government wants to reduce inflation, then they would increase taxes, for example, raising income tax. This reduces consumption as individuals have less disposable income, and so reduces AD, which causes a reduction in the price level.

If a government wants to increase economic growth, they do the opposite – lower taxes. This increases AD as consumption increases due to individuals having greater disposable income, which increases economic output.

The evaluation of one of these methods is the goal of the other – raising tax rates to reduce inflation can harm economic growth, and lowering taxes to increase growth can cause inflation. The government must choose the correct tax rate to balance these conflicting macroeconomic objectives, but often they get this wrong.


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