Fiscal Policy - Impact of Tax Rises (Revision Essay Plan)

Here is an exemplar essay plan to a question on the possible macroeconomic impact of a rise in the tax burden.

Macro Impact of Tax Increases on UK Economy

Extract A

At the Budget in March 2021 the Chancellor announced a phasedrise in UK corporation tax from 19 per cent to 25 per cent, and froze income tax thresholds for five years, raising £17 billion per year and £8 billion per year respectively. The Government has also temporarily increased the rate of National Insurance by 1.25 percentage points, and will introduce a new Health and Social Care Levy from 2024 onwards raising £17 billion per year. These tax rises are forecast to take the UK tax burden to a historically high level. The tax burden is forecast to rise from 33 per cent of GDP recorded before the pandemic in 2019 to 36 per cent of GDP by 2026 – its highest level since the early 1950s.

Government borrowing surged from £57 billion in 2019 to over £300 billion in 2020. At the end of 2021, the National Debt was 96% of GDP. Prior to the pandemic, in November 2019, the debt-to-GDP ratio was 81%.

Question

Evaluate the macroeconomic impacts of an increase in the tax burden on the UK economy. (25 marks)

KAA Point 1

One possible impact of the phased rise in corporation tax from 19% to 25% could be to reduce the level of capital spending by domestic firms and also make the UK economy a less attractive venue for inward FDI. This is because higher corporation tax reduces the post-tax return on investments such as new plant and machinery and factories. Assuming businesses will only go ahead with a project if the expected real return is high enough, a fall in investment would lead to a lower level of aggregate demand (C+I+G+X-M) which in turn will cause weaker economic growth and perhaps also hit productivity since the economy might have a smaller and older capital stock which breaks down more frequently.

Evaluation Point 1

However, many factors influence planned investment spending. These factors include interest rates on corporate loans, the pace of technological change and other tax decisions by the government including the recent super-deduction tax incentive. Under the super-deduction, for every £100,000 a company invests, their taxes are cut by up to £25,000. This has been important for many small businesses. If the economy is still growing and unit labour costs and the exchange rate remain competitive, then a steady rise in corporation tax back towards 25% might have only a limited impact on domestic investment and FDI. For example, corporation tax in Germany is 30 per cent – higher than the UK.

KAA Point 2

A second possible impact of a rise in taxes is a slowdown in consumer spending leading to a rise in unemployment. The extract says that freezing of income tax allowances will raise £8 billion in extra tax and this will then reduce the real disposable income of millions of households which is the main determinant of their spending power. Freezing tax allowances creates something called “fiscal drag” which is a rise in tax as people get wage increases. The jump in national insurance contributions is another direct tax on incomes and it is also paid by employers, which means that many businesses will experience an increase in the costs of employing extra workers. Some may look to control costs by reducing employment and hours for existing workers which will reduce economic growth.

Evaluation Point 2

However, in evaluation, the extract mentions that the pandemic lead to a five-fold in the budget deficit from £57 billion in 2019 to over £300 billion in 2020 and the size of the nationaldebt has expanded by 16% of GDP over the same period. One might argue that a higher tax burden is needed now to helpimprove government finances to ensure that the fiscal deficit has come down before the next recession. A high budget deficit and rising national debt can lead to rising bond yields and higher taxes in the future which could damage prospects for investment and the UK’s international competitiveness.

Final Reasoned Judgement

Overall, the UK government’s decision to raise the tax burden seems to a calculated risk that the economy will be sufficiently strong as the UK emerges from the pandemic and that households and businesses can cope with rising taxes. Some might argue that a rising tax burden is needed now to help pay for growing NHS and social care spending in the post-covid pandemic period. Others believe that there are alternative ways of raising taxes including a windfall tax on the supernormal profits of energy companies and tougher measures to address corporate tax avoidance which is estimated to cost the UK government billions of pounds of lost tax revenue each year.