Income Tax Worksheet - Income Tax - Supplying the Inland Revenue or the economy?

This worksheet looks at the effect of income tax changes on the level of aggregate supply, and considers the role of tax as a supply-side policy. The first step on calculating income tax is the same as worksheet 1 and can obviously be skipped if you have already done worksheet 1.

There is also a printable version of this worksheet available for classroom or personal use with spaces to fill in the answers.

Step 1 - How taxing is tax?

The first step to understanding the effect of income tax changes on supply 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 - 4,195	0%	0	0	0	0	0	0
4,195 - 8,495	20%	4,300	4,300*20% = £860
8,495 - 31,295	23%	22,800	22,800*23% = £5,244
31,295 +	40%	8,705	8,705*40% = £3482
Total income		£40,000
Total tax bill			£9,586

** The figures for £40,000 income are worked out as follows:

The first £4,195 of income (for an unmarried person) is tax-free - hence all the 0 figures in the first row. The next £4,300 of taxable income (i.e. the £4,300 over and above the personal allowance) is taxed at the basic rate of 20%.
The next £22,800 of taxable income is then taxed at 23%. (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 £31,295 is what is taxed at 40%.

Step 2 - Taxing at the margin

Use either the explanation of income tax or the glossary to find out the definitions of the 'marginal rate of tax' and the 'average rate of tax'.

Use the examples in Step 1 to work out the marginal rate of tax (on the next pound earned) and the average rate of tax for each income level.

	Marginal tax rate	Average tax rate
Income level:
£10,000
£40,000
£80,000

At which of these income levels does a person have the most incentive to earn more money?

Why?

If the government wants to create an incentive to work harder, what should it therefore do with the level of taxation?

Cutting top rates of taxation has also been suggested as an appropriate policy. Why should this help the economy?

Step 3 - Supplying tax or taxing the supply?

Use the glossary or your own references to find a definition of supply-side policies and write it down.

Why is cutting taxation a supply-side policy? (N.B. Think back to what we established in Step 2.)

Use the Library section of the Virtual Economy or the glossary to find out the answers to the following questions:

What is 'Say's Law'?

Why is Say's Law important?

Draw a diagram to show the impact that Classical economists argue supply-side policies will have on the economy in the long-run.

Step 4 - A testing theory

We now want to test the impact of supply-side policies on the economy. However, this is difficult. If we simply cut tax, there will also be effects on aggregate demand. Draw on the diagram below the effects on aggregate demand and aggregate supply from a tax cut.

So to try to isolate just the supply-side effects of a tax cut, we will need to make sure that we remove an equivalent amount of demand to the amount the tax cut increases it. We will do this by trying to ensure that the effect on the PSNCR from our tax cuts is zero. This is called a 'revenue-neutral' policy.

Try the following on the model :

• Cut the top rate of tax by a small amount and reduce government expenditure by an equivalent amount
• Cut the top rate of tax by a larger amount and reduce government expenditure by an equivalent amount
• Cut the basic rate of tax in the same way - by a small and by a larger amount

N.B. You may have to experiment to achieve this. Try to keep the value of the PSNCR as close as possible to its pre-reform level. Alternatively, do the tax cut first and see how much tax revenue is affected. Then go back to the model and reduce government expenditure by the same amount.

What effects has this had on the level of growth and unemployment?

		Tax change
Effect on:		Small top rate tax cut	Large top rate tax cut	Small basic rate tax cut	Large basic rate tax cut
1999	Economic growth
	Unemployment
2000	Economic growth
	Unemployment
2001	Economic growth
	Unemployment
2002	Economic growth
	Unemployment
2003	Economic growth
	Unemployment

How successful have these policies been as supply-side policies?

Step 5 - Supplying the demand or demanding the supply?

Use the economic theory section of the Virtual Economy to write an analysis of the views of Keynesian and Classical economists about the relative virtues of demand-side and supply-side policies. Which group advocates the use of which policies and why?

Step 6 - Supplying policies to the economy

Now try using the model to test out some supply-side tax policies. The overall idea should be to aim to improve incentives to work and to reward enterprise. Why not try:

• Cutting marginal tax rates
• Cutting average tax rates
• Cutting average and marginal tax rates

Try to do all these in a revenue-neutral way. That is, try to avoid any increases in the PSNCR as a result of your policies. This will generally mean cutting government expenditure by an equivalent amount to your tax cuts. Make sure also that inflation stays below 4%.

Which policies were the most successful at creating a higher level of growth (without inflation)?

What problems are you likely to face in using supply-side policy as the main tool of economic management?