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Income Tax Worksheet - Income Tax - A demanding tax?
This worksheet deals with how income tax is charged, the effects of different tax changes and the impact they will have on both the macro economy and the micro economy.
Step 1 - How taxing is tax?
The first step to understanding the effect of income tax changes on demand is to see how income tax is calculated. Income tax is charged at different rates for each level of income. For more details on this you may want to look at the explanation of income tax.
In the table below we have worked out the tax bill of an unmarried individual earning £40,000 a year. See if you can fill in the other columns for different levels of income.
| Income level £40,000 | Income level £10,000 | Income level £80,000 | |||||
|---|---|---|---|---|---|---|---|
| Income level | Tax rate | Taxable income | Tax | Taxable income | Tax | Taxable income | Tax |
| 0 - 4535 | 0% | 4535 | 0 | 0 | 0 | 0 | 0 |
| 4536 - 6415 | 10% | 1880 | 1880*10% = £188 | ||||
| 6416 - 33935 | 22% | 27520 | 27520*22% = £6055 | ||||
| 33935 + | 40% | 6065 | 6065*40% = £2426 | ||||
| Total income | £40,000 | ||||||
| Total tax bill | £8,669 | ||||||
** The figures for £40,000 income are worked out as follows:
The first £4,535 of income (for an unmarried person) is tax free - hence all the 0 figures in the first row. The next £1,880 of taxable income (i.e. the £1,880 over and above the personal allowance) is taxed at the lower rate of 10%.
The next £27,520 of taxable income is then taxed at 22%. In the case of the person earning £10,000 this will clearly only be a small amount of their income.
Anything over and above this is then taxed at 40%, though many people's earnings will obviously never make it into this band. In the case above, the rest of the £40,000 left over and above £33,935 is what is taxed at 40%.
Step 2 - How do you rate tax?
If you've arrived at this stage without a total brain meltdown, you'll have realised that tax is not a simple issue! This is important - not because we're trying to muddle you, but because different tax changes will have different effects on the economy.
To show this let's try an experiment on the Virtual Economy. We're going to look at the different effects of changing tax rates and tax allowances. Go to the model
and try the strategies given below. Write the results in the table below:
- First - try cutting tax by increasing the personal allowance by £2,000. Record the results in the table below.
- Second - try an equivalent tax cut, but this time by cutting the basic tax rate by 2%. Again record the results below.
| Tax rate cut | Tax allowance increase | ||
|---|---|---|---|
| Effect on: | |||
| Macro economy | |||
| 2001 | Economic growth | ||
| Unemployment | |||
| Inflation | |||
| 2002 | Economic growth | ||
| Unemployment | |||
| Inflation | |||
| 2003 | Economic growth | ||
| Unemployment | |||
| Inflation | |||
| ******************** | ******************** | ||
| Micro economy | |||
| Single earner couple with 2 children earning £12,000 | |||
| Single earner couple with 2 children earning £17,000 | |||
| Two earner couple with 2 children earning £50,000 | |||
In the table below, work out the percentage gain for each family for the above policies. To do this go through the following steps:
- Multiply the weekly gain by 52 weeks to get the annual gain.
- Then calculate how much this is as a percentage of the original income level
- Do this for both policies
| Family | Weekly gain (£) |
Annual gain (£)
weekly gain x 52 |
Percentage gain (%)
annual gain as % of income | |
|---|---|---|---|---|
| Single earner couple with 2 children earning £12,000 | Tax cut | |||
| Tax allowance change | ||||
| Single earner couple with 2 children earning £17,000 | Tax cut | |||
| Tax allowance change | ||||
| Two earner couple with 2 children earning £50,000 | Tax cut | |||
| Tax allowance change |
Which group has gained the most from the tax rate cut?
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Which group has gained the least from the tax rate cut?
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Which group has gained the most from the tax allowance increase?
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Which group has gained the least from the tax allowance increase?
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Step 3 - Progressing further with tax
We have seen above that the same tax cut can have very different effects. A cut in tax rates benefits all taxpayers and so will give relatively more to the better-off. An increase in personal allowances however, gives exactly the same financial benefit to everyone. This will therefore be of more value relatively to the less well-off.
Mark in the table below which group you think will benefit the most from each of the tax changes given; the better-off or the less well-off.
| Tax change | Who benefits the most? | |
|---|---|---|
| Better-off? | Less well-off? | |
| Cutting the top rate of tax | ||
| Increasing personal allowances | ||
| Cutting VAT | ||
| Cutting the basic rate of tax | ||
| Reducing tax on cigarettes | ||
There is an explanation in the theory section for income tax of progressive and regressive taxes that may help with this question.
If those on higher incomes and those on lower incomes are both given the same tax cut, which group is likely to spend more of it?
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Why?
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Step 4 - Demanding tax cuts?
We can now see that increasing or reducing taxes will affect the level of demand in the economy. The total level of demand in the economy is known as aggregate demand
.
What are the main components of aggregate demand?
AD = __ + __ + __ + ( __ - __ )
What effect would the following tax changes have on the level of aggregate demand?
| Tax change | Effect on aggregate demand? Increase or decrease? |
|---|---|
| 1.. A cut in the basic rate of tax | |
| 2.. An increase in personal allowances | |
| 3.. Increasing the top rate of tax | |
| 4.. Not increasing allowances and thresholds in line with inflation |
N.B The last of these changes - not increasing allowances and thresholds - is termed fiscal drag
.
Illustrate each of the above changes on the graph below. AD is the original level of aggregate demand. Draw new curves to show each of the four changes above.
Step 5 - Aiming tax at the targets
If tax changes affect the level of aggregate demand, then they will also affect all the main economic targets. To see how the targets are affected we will experiment again on the Virtual Economy. Try the following and fill the results in in the table below:
- A small tax cut (cutting tax rates a little and increasing allowances a little)
- A large tax cut (changing rates and allowances a lot)
- A small tax increase (increasing tax rates a little and reducing allowances a little)
- A large tax increase (changing rates and allowances a lot)
Try these changes on the model
and then in the table try to fill in approximately the amount that each of the targets has changed:
| Tax change | |||||
|---|---|---|---|---|---|
| Effect on: | Small tax cut | Large tax cut | Small tax increase | Large tax increase | |
| 2001 | Economic Growth | ||||
| Inflation | |||||
| Unemployment | |||||
| Balance of Payments | |||||
| 2002 | Economic Growth | ||||
| Inflation | |||||
| Unemployment | |||||
| Balance of Payments | |||||
| 2003 | Economic Growth | ||||
| Inflation | |||||
| Unemployment | |||||
| Balance of Payments | |||||
| 2004 | Economic Growth | ||||
| Inflation | |||||
| Unemployment | |||||
| Balance of Payments | |||||
Show each of these changes on the diagram below. (N.B. try to think carefully how much aggregate demand has changed by for each change. You should be able to tell this from the changes in growth and inflation.)
Step 6 - Demanding policies?
We can see from above and our experiments on the Virtual Economy that changing income tax will have significant effects on the economy. However, there are differences of opinion between economists as to whether using tax to control the economy is appropriate. These policies are known as demand management policies
as they aim to manage the level of aggregate demand to get to a full employment equilibrium.
Use the library section of the Virtual Economy to answer the following questions:
What is meant by 'counter-cyclical demand management'?
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What is the view of classical economists over using demand management policies?
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Draw an aggregate demand and supply diagram on the axes below to show the effect that classical economists argue there will be in the long-run if the government pursue a policy of cutting taxes to boost the level of demand.
What is the Keynesian view of demand management policies?
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Step 7 - A demanding way to manage the economy?
Having seen how income tax policy can be used to manage the economy, go once again to the model
and try changing income tax to get the best level of growth and unemployment possible while keeping inflation below 4%.
What changes gave the best level of growth?
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What problems might you expect if you were to continue these policies for a number of years?
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