Stating your assumptions carefully, outline the likely impact of an increase in taxation on the interest rate.

Before discussing the effects of increased taxation on the interest rate, it is important to distinguish what type of taxation is being increased. Taxation is defined as any compulsory payment from an individual or institution to central or local government. There are two main types of tax – direct and indirect taxes. Direct taxes are taxes on income (a percentage of a worker’s wage), profits (a percentage of a firm’s profits) and wealth (for example a percentage of somebody’s inheritance). Indirect taxes are taxes on consumption, for example Value Added Tax, which is a percentage of the price of a good sold. An increase in the rate of any of these taxes will have a similar effect on the economy as a whole. However the government can use taxation to target certain parts of the economy for taxation revenue. For example to reduce investment spending it could increase corporation tax.

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If the government were to increase income tax, the effect on the economy would be that the level of aggregate demand would fall, assuming that all other factors remained constant (ceteris parabus). This has the effect of reducing the economy’s expenditure. This would have the effect of shifting the IS curve inwards, to the left, reducing the level of income and output in the economy. If the increase in tax was on income tax, then there would be less consumption because the marginal propensity to consume (MPC) would fall. The marginal propensity to consume is the percentage of each pound earned that is spent. As well as this, if the tax increased was corporation tax, the level of planned investment would fall because of lower profitability in firms. The IS-LM model shows that when the IS curve shifts inwards, the equilibrium level of income and output falls. This is shown by figure 1, where as IS shifts to IS1, the equilibrium level of income falls from Y1 to Y2. The magnitude of the shift of the IS curve is determined by the tax multiplier and the size of the change in the tax rate. The tax multiplier can be calculated as MPC/ (1 – MPC). The level of income initially falls to Y2.

At this point, the interest rate will fall so that the IS and LM curves are in equilibrium. They will decrease from r1 to r2. When this happens, both the goods and money markets will be in equilibrium, and money demand will be equal to money supply. The reduction in the interest rate has the effect of increasing investment, and so the equilibrium level of income rises from Y2 to Y3.

There are many factors which can affect the way a reduction in taxation changes the interest rate. Firstly the size of the change in tax rates will be a major factor. If the rise is relatively small, then in reality, the interest rate may not even change. However a large increase in taxes will have a big effect on the behaviour of the interest rate. As well as this, if the tax multiplier is large, then the reduction in interest rates will also be relatively large. The tax multiplier is dependent upon the marginal propensity to consume, and a large MPC will result in a large tax multiplier. If there is a large tax multiplier, then even a relatively small change in tax rates will mean a large shift in the IS curve and, as a result, a large reduction in interest rates. The slope of the IS and LM curves can also dictate how the interest rate is affected. The slope of the IS curve is affected by the responsiveness of investment spending to a change of interest rates and if it is high, the IS curve will be steep. The LM curve will be steep if the demand for money is very responsive to changes in income but not very responsive to the interest rate. If the LM curve is very steep but the IS curve is flat, the change in the interest rate will be relatively big compared to the change in taxation. This is shown by figure 2, where a shift left of the IS curve creates a large reduction in interest rates. On the other hand, figure 3 shows the effects of an increase in taxation if the IS curve is step and the LM curve is flat. The change in interest rates here is relatively small. To say this I have to assume that price levels are constant and that firms are willing to supply whatever amount of goods are demanded at that price.

Peer Reviews

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groat

3rd of Mar 2012

Quality of writing

This essay is structured well, having a clear introduction defining the key terms, and a strong conclusion posing a justified judgement. The points are well detailed, and it always stays on focus throughout. Technical terms are used well, and spelling, punctuation and grammar are strong. A strong essay!

Level of analysis

The analysis in this essay is strong, but as the diagrams are not included I can only assume they were right. There is a good awareness shown between indirect and direct taxes, and relevant examples are used well. What is particularly good about this essay is the explanation of the diagram. For example referring to "where IS shifts to IS1, the equilibrium level of income falls from Y1 to Y2" shows a full understanding of the diagram and the effects a shift can cause. There are some sophisticated concepts explored here, such as the marginal propensity to consume, which shows a strong understanding. I was pleased to see the phrase "ceteris paribus" used, as the task clearly states to mention any assumptions. By using this, it shows that you understand you cannot look at the changes without isolating one variable, whilst keeping the rest equal. The evaluative paragraph is very strong, picking out reasons why the change in interest rate isn't as clear cut. Being able to pick out determining factors, or external influences is a great way to get evaluative marks! I particularly liked the language used such as "the tax multiplier is dependent upon", "on the other hand" and "if the LM curve is very steep" as it shows a strong understanding of multiple factors and different situations.

Response to question

This essay engages superbly with the question. I liked how there was a progression from defining taxation onto analysis of how it affects interest rates, and then an evaluative paragraph discussing what other factors need to be considered. A clear structure such as this ensures that the essay is always focused on the task, whilst still showing all the skills necessary.

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