Discuss the assertion that the sole purpose of the tax system is to promote economic growth. Illustrate your answer with reference to examples from British and American tax policy over the last ten years

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22/4/2013                                             Z0932142

1.0 Introduction

Governments are all committed, to some extent, to provide services for the population. This can be through provision of the legal system, defence, health services, as well as infrastructure such as roads. They must acquire funds in order to be able to fund such public expenditure. 

"The point to remember is that what the government gives, it must first take away."  (Coleman, 1956)

Revenue can be obtained through borrowing, but is more commonly obtained via taxation. Taxation is a government system that enforces levies or extractions on income, profit, expenditure or capital assets. It represents the transfer of resources from the taxpayers to the government. Historically, the sole purpose of this transfer was to finance public expenditure. While tax systems are still required primarily for financing public spending, nowadays they also aim to promote and address other social and economic concerns.

In today’s world, there is extreme diversity in the types of tax systems used by governments. Disreali (1862) stated that expenditure depends on policy. Taxation and policy are linked no less in 2013 than they did in 1862. The consequences of taxation affect many household decisions including the savings decision and investment in human capital. Taxation also affects the decisions of firms to produce, create jobs, invest and innovate, as well as the choice of savings channels and assets by investors. (Johansson et al, 2008)

The idea that taxes affect economic growth has become politically argumentative and the subject of much debate in the process among support groups (McBride, 2012). This is mainly because there are conflicting theories for how economic growth is driven. Opinions are divided between Keynesian, demand-side factors and Neo-classical, supply-side factors. McBride’s report quotes, “…the economy is sufficiently complex that virtually any theory can find some support in the data”, explaining why the historical facts and figures are still unable to shed light on the issue. Miller and Oats, (2012), claimed that there are three functions that require the imposition of taxes: provision of public goods, distribution of resources, and economic stabilisation. In this paper, I focus on the Keynesian view and demand-side factors used to stimulate growth in OECD countries. I pay particular interest to the taxation policies of Britain and the US of the 21st century and how the policies have been used to satisfy these functions.

2.0. Tax policies and Economic Growth

To understand the extent to which the tax system promotes economic growth, we must first understand the concept of economic growth.

A relatively small part of the world achieved what economists call modern economic growth. Economic growth is the expansion of the economy’s production possibilities, and is measured as the increase in real gross domestic product (GDP) (Parkin et al, 2008). Economic growth is stimulated in the short run by the increase in aggregate demand within the economy. Aggregate demand is determined by the factors in figure 2.1. An increase in any one of these factors, ceteris paribus, causes economic growth to occur.

Consumer spending (C), or consumption, represents the expenditure of the population on goods and services within the economy. Capital Investment (I) represents the investment on property, plant and equipment, which will influence the future production of consumer goods. In Britain, capital investment accounts for 16-20% of GDP each year, with roughly 75% being investment from private businesses and 25% being government expenditure on improving current services or creating new ones. Government spending (G) is spending on state-provided goods and services. The level of expenditure by the government will fluctuate annually depending on development and political priorities. Similar to capital investment, government expenditure also account for 18-20% of GDP in Britain. This figure generally understates the true size of the government sector within the economy. Government spending is usually concentrated on welfare state payments, with a smaller proportion spent on investment. However, current government spending does not include state pensions or job seekers allowance, as these represent a transfer payment from one group of the population to another. Exports (X) of goods and services represent an inflow of demand into an economy’s income and expenditure, increasing aggregate demand. The opposite process of importing goods and services (M) has a negative effect on the circular flow of income and expenditure, decreasing aggregate demand. ‘Net exports’ is a term used to describe the value of exports less the value of imports. There is either a trade surplus, when exports are greater than imports, or a trade deficit, when imports exceed exports. One of the aims of fiscal policy is to achieve positive net exports, a trade surplus, increasing demand and therefore achieving economic growth. In recent years Britain has been running a sizeable trade deficit. (Riley, 2012)

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Governments will employ fiscal policy in order to control the growth rates within the economy under fluctuating economic conditions. The use of and movement of resources, along with international exchanges, are the key processes that influence the wealth level of a country. Fiscal policy is the process of shaping taxation and government expenditure to influence aggregate demand (Parkin et al, 2008). Fiscal policy can have powerful effects, but these effects will vary according to different circumstances. For example, during times of recession, an expansionary fiscal policy involving tax cuts, tax credits and increased government spending can refuel the economy; ...

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