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 workers pay basic-rate tax.
But: People earning below the personal allowance pay no income tax and gain nothing.
2
This means consumption rises and AD shifts right.
consumption · aggregate demand
consumption · aggregate demand
Assumes: Households spend rather than save the gain.
But: If households are worried about their jobs or have high debts, they save much of the gain, and some spending goes on imports.
3
Consequently, firms that are already close to full capacity cannot easily raise output, so they raise prices instead.
demand-pull inflation · output gap
demand-pull inflation · output gap
Best link to attack
Assumes: The economy is close to full capacity.
Assumes: The economy is close to full capacity.
But: With a negative output gap, firms meet the extra demand from idle capacity and unemployed workers, so output rises with little rise in prices.
4
In addition, a tighter labour market lets workers bargain for higher wages, which raises firms' unit labour costs and leads to further price rises.
cost-push inflation · unit labour costs
cost-push inflation · unit labour costs
Assumes: Workers have the bargaining power to push up wages.
But: Where union power is weak and the inflation target is credible, inflation expectations stay anchored and wage demands stay moderate.
End
Demand-pull inflation rises, especially if the economy is already close to full capacity.
Evaluation chain
- E1However, the effect on inflation depends on how much spare capacity the economy has when the tax is cut.
- E2If the economy is in a downturn with a negative output gap, firms have idle machinery and there are unemployed workers to hire.
- E3As a result, the extra demand is met mainly by higher real output and employment, and firms have little reason to raise prices.
- E4So an income tax cut adds little to inflation in a downturn, but adds much more when the economy is already close to full capacity.
Another way to attack it: The Bank of England may raise Bank Rate to offset the extra demand, limiting the rise in inflation. If higher take-home pay draws more people into work, LRAS shifts right and eases the pressure on prices.
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Questions this answers
- Assess the likely impact of a cut in income tax on the rate of inflation.
- Discuss whether expansionary fiscal policy is always inflationary.
- Explain how a cut in direct taxes might lead to demand-pull inflation.
Diagram
AD/AS: AD shifts right. On a Keynesian AS curve the price level rises little where there is spare capacity and much more close to full capacity.
Reverse and related
Income tax rise → lower disposable income → AD falls → inflationary pressure eases.