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, workers paying the basic rate keep more of their pay, so disposable income rises.
disposable income
disposable income
Assumes: Most households pay basic-rate tax.
But: People earning below the personal allowance pay no income tax and gain nothing.
2
This means consumption rises, because basic-rate taxpayers tend to spend a high share of any extra income.
marginal propensity to consume
marginal propensity to consume
Best link to attack
Assumes: Households spend rather than save the gain.
Assumes: Households spend rather than save the gain.
But: If households are worried about jobs or paying down debt, they save much of the gain, and some spending leaks into imports.
3
Consequently, AD shifts right and, through the multiplier, real output rises by more than the first rise in spending.
multiplier
multiplier
Assumes: There is spare capacity.
But: Near full capacity, the extra demand raises prices rather than output.
4
In addition, higher take-home pay raises the reward for working, so some people work more hours or join the labour force, shifting LRAS right.
incentives · LRAS
incentives · LRAS
Assumes: Labour supply responds to take-home pay.
But: Some people may use the higher pay to work fewer hours for the same income (the income effect), and for most workers the response is small.
End
Real GDP growth rises, through higher AD and possibly a rise in LRAS.
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Questions this answers
- Assess the impact of a cut in income tax on economic growth.
- Discuss whether lower income tax increases the incentive to work.
- Evaluate the demand-side and supply-side effects of a cut in income tax.
Diagram
AD/AS: AD shifts right; LRAS may also shift right if labour supply increases.
Reverse and related
Income tax rise → lower disposable income → consumption and growth fall.