Income levels derived from personal taxation, company taxation and the cost of borrowing determine the state of the government finances. The current predictions for reduced economic growth are based on predictions that UK manufacturing out put would be 4% lower in 2002 than in 2001 and even lower in 2004 than in 2001. Although this will be partially offset by a projected increase in consumer spending, which is believed to be sourced by manufacturers reducing their inventory levels, rather than manufacturing more.
At the same time subdued growth in the world economy and falling equity markets has led to a raising of the cost of equity capital resulting in lower business investment, which will subsequently result in lower output levels, leading to a further reduction of taxed income to the government.
This situation is predicted to be further adversely affected by a reduction of ‘household’ tax revenue as people are either forced or choose to save more to reflect the changing pensions situation.
What would be the effect of a £20billion tax rise on the levels of output and employment in the economy?
To prevent a £20billion deficit the Government has three options - tax more, spend less or increase borrowing. Whatever decision the Chancellor makes it is likely to have as impact on the wealth of the person in the street.
Taxing more and spending less would take money out of the economy and could lead to unemployment and a crisis in the housing market – the buoyancy of which is a key to consumer confidence. As for borrowing more, its first seems the least painful option but if the Government was to get its sums wrong it could then lead to higher interest rates which could push the economy into recession. For the Government spending less is not an option given its election pledge to improve public services.
For the short term it seems that borrowing is the way the Chancellor plans to go, as he is relatively free to increase borrowing. The Government has paid back more than £50billion of its debt over recent years and it is easy to build it up again without any difficulties.
However if money markets believe that Britain is heading into debt then it is likely that the government will have to pay more for its borrowings, which as a result could lead to rising interest rates across the economy, causing the housing market to take a fall, bringing recession closer which in turn will hit tax revenue.
If you split the economy into four parts – investment, exports, consumer spending and government spending, it’s the first two components that have failed to meet expectations. Businesses are still reluctant to buy new machinery or invest in new technology given the uncertain outlook, lack of finances and the excess capacity left over from the dotcom boom. Exports have also suffered because of the global downturn and the high pound – a serious blow to the economy since they contribute to around a third of GDP growth. This in turn leaves the Government and the consumers to carry the can.
The diagram shows the circular flow of income with the UK economy. Where the components of national output are consumer consumption, investment, and government spending on goods and services – which is paid for by raising revenue from taxes (T). In the event of the government needing to borrow, it can borrow from the financial market, which is funded by household savings; therefore there is less finance for investment or from the rest of the world (ROW).
As was mentioned before the government is likely to avoid the deficit by borrowing, it can do this one of two ways; firstly by printing money – the effect of which can be seen in route 1. Where AD1 will shift to AD2, but have only a temporary effect On GDP and jobs. GDP returns to its natural rate on the LRScurve, but with higher inflation.
Secondly by borrowing from non-bank institutions/ individuals/ rest of the world, then this will lead to higher interest rates to encourage those groups to buy more government securities; this rise in interest rates will in turn cause firms to invest less, consumers to spend less, and a rise in the value of the exchange rate which will reduce exports – the effect of this can be seen in route 2.
Taxes can have a multiplier effect as can government spending, but the multiplier effect of tax changes is likely to be lower than for government spending (or for investment or exports); the reason is simply because changes in taxation do not have a full effect on demand; they only effect demand to the extent that the income taken by the government would have been spent, but some of that money would have been saved; demand only changes therefore by the marginal propensity to consume.
As a general economic theory, increased business taxation leads to either reduced profitability and hence ultimately a reduction overall in tax income, or increased prices leading to a reduction in competitiveness and again potentially to reduced profitability and again reductions in overall tax income.
In respect of personal or individual taxation, unless the economy is in expansion to compensate, the net result is that the more an individual is taxed the less is available for reflective choice spending. This will manifest its self into the economy in one or two ways, or more likely a combination of both.
Firstly less money will be spent in the domestic consumer markets reducing tax revenue and possibly more significantly suppressing demand and ultimately suppressing manufacturing demand and therefore output. Secondly, consumer pressure will create a market for cheaper imported goods, overall this may equalise tax income from the consumer sector, but it will undoubtedly further damage the demand for domestic manufactured goods and further reduce the tax revenue from this sector of the economy.
Further, any reduction in output within the domestic economy will have associated job losses leading to lower levels of employment or increased levels of unemployment, in turn leading to higher social service costs and again lower individual tax income.
The impact of increased taxation on manufacturing output and employment in the economy could be summarised as follows:
- Increased corporation taxation will reduce competitiveness and hence low tax revenue, ultimately leading to reduced output, increased levels of unemployment and higher social services costs.
- Increased personal taxation will reduce personal spending power, leading to lower demand on domestic production and/or an increased demand for cheaper imports, both of which will lead to lower tax revenues and ultimately increased levels of unemployment which in turn will reduce personal tax revenues and increase the social security budget.
In other words, a self-fuelling phenomenon whereby increasing taxation outside of the levels that can be met by the national gross income will result in the need for further taxation to meet spending limits based outside the current national gross income capability.
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Bibliography:
http://news.bbc.co.uk
www.niesr.ac.uk
www.statistics.gov.uk
www.telegraph.co.uk
Staffordshire University Lecture Notes, R.Ledward, 2002
http://business.staffs.ac.uk/bsmw/BS1364-2.htm