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 households spend part of the extra income on imported goods and services, such as cars, electronics and holidays abroad.
marginal propensity to import
marginal propensity to import
Best link to attack
Assumes: Households spend a large share of extra income on imports.
Assumes: Households spend a large share of extra income on imports.
But: If households save the gain, or spend it on UK services such as eating out and leisure, little of it goes on imports.
3
In addition, the extra demand may raise UK inflation above that of trading partners, making UK goods less price competitive.
relative inflation · international competitiveness
relative inflation · international competitiveness
Assumes: The economy is close to full capacity.
But: With spare capacity, the extra demand causes little inflation, so competitiveness barely changes.
4
Therefore, spending on imports rises relative to export earnings, so the trade balance worsens.
trade balance · current account
trade balance · current account
Assumes: The exchange rate does not move to offset it.
But: A wider deficit means more pounds are supplied to buy imports; if the pound depreciates, exports become cheaper and imports dearer, correcting part of the deficit.
End
The trade deficit widens, because higher incomes are partly spent on imports.
Evaluation chain
- E1However, the effect on the trade balance depends on how much of the extra spending goes on imports.
- E2If households save the gain, or spend it mainly on UK services such as restaurants, leisure and home improvements,
- E3then only a small part of the tax cut leaks abroad, so imports rise only slightly.
- E4So the trade balance may worsen only a little, and much less than after a tax cut spent mainly on imported cars and electronics.
Another way to attack it: If the tax cut raises the incentive to work and so raises labour supply, productive capacity grows and some extra output may be exported in the long run, but this effect is usually small.
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Questions this answers
- Assess the impact of a cut in income tax on the trade balance.
- Discuss the extent to which expansionary fiscal policy conflicts with a balanced current account.
- Explain why a rise in disposable income might lead to an increase in imports.
Diagram
No standard diagram. The circular flow, with imports shown as a withdrawal, makes the link clear.
Reverse and related
Income tax rise → lower disposable income → fewer imports → trade balance improves (expenditure-reducing policy).