Tuesday, May 15, 2007

Purpose and Merits of Taxation

1. Finance Government Spending.

2. Reduce inequality. Higher income tax can help to reduce inequality. For example, the top rate of income tax (40% on incomes over £27,000) is a progressive tax. It takes a higher % of income from high earners.

3. Reduce consumption of De Merit Goods. These are goods like alcohol and tobacco. They have negative externalities.(costs to third parties e.g. passive smoking); they are also good where consumers underestimate benefits. Examples include cigarette tax and excise duty.

Essay Question: The government wishes to increase spending on the NHS and financing it by increasing taxes. Discuss the economic effects. (30) AQA

1. Effect on AD.

Higher government spending increases AD, however, the increase in tax will have the opposite impact of reducing consumer spending. Therefore overall the net impact on AD will be neutral.

However, it is possible that AD rises, if consumer confidence was high and increased taxes led to lower savings amongst consumers. This is unlikely thought.

2. Incentive Effects of Higher taxes.

An increase income tax could reduce work incentives. Higher tax makes work less attractive (substitution effect). However, there is also the income effect, which states that higher income tax reduces income and therefore, encourages people to work more. Overall, the impact is likely to be negligible; this is because income tax rates are low, and a modest increase will not reduce incentives.
The government may prefer to increase indirect taxes, such as; VAT and excise duties.

3. Effect on Inequality

If the government increased income tax on high earners, inequality is likely to fall. However, if they increased indirect taxes inequality is likely to rise; this is because taxes are regressive.

4. Crowding Out.

Increased spending and taxation, increases the size of public spending as a % of GDP. It is argued by some economists that government spending is more inefficient than private spending. For example, government spending is subject to admin costs, and a lack of financial incentives. Therefore in the long run, economic growth may fall due to the increased inefficiency.

However, it could be argued that government spending can actually increase productive capacity, by overcoming market failure. For example, better health care may lead to a healthier and more productive workforce. This argument would be stronger if it was for education and training.

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