Fiscal policy and supply-side policies

A person earning 20,000 pounds pays 2,000 pounds in tax; a person earning 50,000 pounds pays 9,000 pounds. Is the tax progressive, proportional or regressive?

1. 01Average rate at 20,000

   Average tax rate = 2,000 / 20,000 x 100 = 10%.

2. 02Average rate at 50,000

   Average tax rate = 9,000 / 50,000 x 100 = 18%.

3. 03Compare

   The average rate RISES with income (from 10% to 18%), so the tax is PROGRESSIVE - the higher earner pays a larger proportion, not just a larger amount.

Result: The average rate rises from 10% to 18% as income rises, so the tax is progressive.

A government has revenue of 800 bn and spending of 850 bn pounds, and starts the year with a national debt of 2,000 bn. Find the budget balance and the debt at year end. Then a recession cuts revenue by 40 bn and raises spending by 30 bn; find the new deficit.

1. 01Budget balance and new debt

   Balance = 800 - 850 = -50 bn (a 50 bn deficit). The debt rises by the deficit: 2,000 + 50 = 2,050 bn at year end.

2. 02Effect of the recession

   Revenue falls to 760 bn and spending rises to 880 bn, so the new deficit = 760 - 880 = -120 bn.

3. 03Interpret the automatic stabilisers

   The deficit widens automatically from 50 to 120 bn in the recession (lower tax revenue, higher benefits) - the automatic stabilisers supporting demand. Much of the extra deficit is cyclical and would unwind as the economy recovers.

Result: The 50 bn deficit raises the debt to 2,050 bn; the recession widens the deficit to 120 bn automatically, most of it cyclical rather than structural.

A government invests heavily in education and infrastructure. Explain, using AD/AS, why this differs from a demand stimulus of the same size, and one drawback.

1. 01The supply-side effect

   Better education and infrastructure raise the quantity and productivity of the factors of production, shifting LRAS RIGHT - the economy's capacity grows.

2. 02Contrast with a demand stimulus

   A demand stimulus shifts AD right, raising output but also the price level (inflation). The LRAS shift instead raises output while LOWERING the price level - growth without inflation, reconciling objectives that a demand stimulus puts in conflict.

3. 03State a drawback

   The gains take years to appear (long time lags) and the spending raises the budget deficit now, so supply-side policy cannot substitute for demand-side support in an immediate recession - the two are complements.

Result: Supply-side investment shifts LRAS right (raising output, lowering prices), unlike a demand stimulus - but its long time lags and fiscal cost mean it complements, not replaces, demand policy.

A country's top income-tax rate is currently well below the revenue-maximising rate. The government cuts it, hoping to raise revenue. Using the Laffer curve, assess whether it will.

1. 01Locate the economy on the curve

   If the current rate is BELOW the revenue-maximising peak, the economy is on the RISING part of the Laffer curve, where a higher rate would raise revenue and a lower rate would cut it.

2. 02Predict the effect of the cut

   Cutting the rate from a point on the rising section reduces revenue: the incentive gains are too small to offset the lower rate applied to the tax base.

3. 03Add the condition

   The cut would raise revenue ONLY if the economy were beyond the peak (on the falling section). Since it is not, the claim fails here - though the cut may still be justified on other grounds (incentives, growth).

Result: Because the country is on the rising part of the Laffer curve, the tax cut will REDUCE revenue; the 'cuts pay for themselves' claim only holds beyond the revenue-maximising peak.