ChainWhat it assumes · how to break it
Start
The government cuts the basic rate of income tax, for example from 20% to 18%.
1
As a result, at the existing level of income, income tax receipts fall: each penny on the basic rate is worth several billion pounds a year.
tax revenue
tax revenue
Assumes: Incomes do not change straight away.
But: This direct cost is certain; only the size of the later offsets is in doubt.
2
This means unless spending is cut, the budget deficit widens and borrowing rises.
budget deficit
budget deficit
Assumes: Spending is not cut to match.
But: If the cut is paid for by spending cuts, the deficit is unchanged but public services suffer.
3
At the same time, higher disposable income raises spending, so VAT receipts rise and benefit spending falls, recovering part of the cost.
automatic stabilisers
automatic stabilisers
Assumes: The extra income is spent.
But: If households save the gain, little comes back through other taxes.
4
In addition, if the cut encourages people to work and earn more, the tax base grows and recovers more of the cost.
Laffer curve
Laffer curve
Best link to attack
Assumes: Tax rates are high enough for cuts to raise activity a lot.
Assumes: Tax rates are high enough for cuts to raise activity a lot.
But: The UK basic rate is well below the rate that maximises revenue, so a cut loses revenue overall. Laffer effects are more plausible for the top rate.
End
The budget deficit widens, but by less than the direct cost of the cut.
Evaluation chain
- E1However, whether the cut recovers its cost depends on where the current tax rate sits on the Laffer curve.
- E2This is because revenue rises after a cut only if the starting rate is so high that people work much less or avoid tax at that rate.
- E3As a result, with the UK basic rate at 20%, well below the revenue-maximising rate, behaviour changes too little to offset the lost revenue.
- E4So the cut loses revenue overall and the deficit widens; Laffer effects are more plausible for the top rate.
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Questions this answers
- Explain how a cut in income tax might affect the budget deficit.
- Assess the view that tax cuts pay for themselves.
- Discuss the use of the Laffer curve to justify cutting taxes.
Diagram
Laffer curve: a cut from a rate to the left of the peak reduces revenue; only a cut from the right of the peak raises it.
Reverse and related
Income tax rise → receipts rise → deficit narrows.