Saturday, November 15, 2008

Will Tax Cut Often Works To Revive Economy?

"Gordon Brown has fuelled talk of possible tax cuts by saying they could help to support consumer spending"

--BBC, 11th November 08—


(1) Demand side effect. In theory, by reducing income tax working individual will have higher disposable income. This will encourage more spending into the economy. By lowering down corporation tax, firms will have greater retained profits. Therefore this may encourage them to conduct R&D & expand their operation. Both lead to increase in AD, through the increase in C & I. Real economy will increase

(2) Supply side effect. With lower tax, individuals will have incentive to work hard or taking up jobs. This is because the more they work the more they get to keep for themselves. For firms, lower corporation tax or tax investment credit will give them incentives to take up R&D activities. They may make more discoveries on methods to increase productivity or lowering down the costs of production. AS shifts rightward. If successfully implemented, there will be lower inflationary pressure & increase in real GDP

Evaluation of tax cut

(1) What if too small?
If the tax cut is too small, it may not be successful to persuade people to start spending into the economy. This is likely true given the current situation of UK economy. In period where consumer confidence is low, most likely those tax cut will not be spent, but rather saved

(2) Tax cut affects who? Depends on who will be affected, the low income or the high income? If the tax cut is on high income earners, large proportion of the money will not be spent but rather saved. But if it’s targeted on the low-income earners, assuming the tax cut is ‘large enough’, it will be successful at increasing spending. The logic is lower income people have more things to own than the rich ones

(3) Tax cut vs. government spending.
It is argued that direct government spending into the economy is more effective to revive the economy, create employment & thus restore confidence among Britons. When government decides to upgrade infrastructures for the upcoming London Olympic 2012, construct new schools, hospitals & other public works has the ability to create tenths of thousands of new jobs, thus ensuring greater overall private consumption into the economy

(4) Crowding out effect
. Tax cut directly means lower revenue for the government. To finance public works, this necessarily means UK government has to raise borrowing by the issuance of government bond. The bond will be normally taken up by private sectors, therefore leaving them with lower funds available to spend & invest. Also as UK government’s debt is mounting, it is increasingly difficult to raise financing. Therefore they may have to increase interest rates to attract lenders. Financial institutions may follow suit, or else they will lose all the depositors. Therefore we say, firms are crowd out by the way of higher interest rates. In nutshell, tax cut to revive economy could be overshadowed by the declining prospects of private sectors

(5) Politicians are forgetful. The problem with cutting tax is that politicians often ‘forget’ to reverse them in the period of economic boom. The truth is they are unwilling to watch the economy crawl then (slowing down). Even if they decide to increase, there will be many industries lobbying not to. This could be one of the reasons why US National Debt has surpassed $ 10 trillion, standing at 70% of its GDP. It is often easy to make tax cut during recession, but no calls being made to increase it to bring it back to equilibrium in good times

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