VAT Worksheet - VAT - A demanding tax

This worksheet deals with how indirect tax changes will affect the macroeconomy. It considers the impact of VAT changes on the level of aggregate demand and the major economic targets.

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

Step 1 - A demanding tax

Aggregate demand (AD) is the total level of planned spending in the economy. It is made up of spending by consumers (consumption - C), spending by firms on machinery and equipment (investment - I), spending by government (government expenditure - G) and net spending from abroad (exports-imports - X-M).

Which component of aggregate demand will be affected by changes in the level of VAT and indirect taxes?

If the government were to increase VAT significantly, what would be the effect on the level of aggregate demand?

Show this change on the diagram below:

Would you expect the effect on aggregate demand of changes in other indirect taxes to be larger or smaller than the effect of changes in VAT? Why?

Step 2 - Turning up the VAT

As we established above, any change in VAT is likely to have an impact on aggregate demand. This will therefore affect the rest of the economy as well. Say the government decided to substantially increase the level of VAT. Fill in below the effects you would expect on each of the economic variables given:

Inflation	Higher / lower / the same?	_________________
Unemployment	Higher / lower / the same?	_________________
Economic growth	Higher / lower / the same?	_________________
PSNCR	Higher / lower / the same?	_________________

Why do you think these changes will happen?

So were your 'expectations great'? Now try actually carrying out a 2.5 percentage point increase in VAT on the model. You can access the model either on the 4th floor of the side panel or from the navigation bar at the top of the page. What are the effects on the economy? Fill them in below:

	1999		2000		2001		2004
	Before change	After change	Before change	After change	Before change	After change	Before change	After change
Inflation (%)
Unemployment (% of work-force)
Economic growth (GDP growth) (%)
PSNCR (£bn)

Write a short paragraph describing the changes that occurred in the economy and how they varied over time.

Step 3 - A taxing tool

Try the same change in VAT as in Step 2 - a 2.5 percentage point increase. Note down, in the table below, the effect of this change on the families given. From the weekly change in income, calculate the annual gain/loss and also the percentage gain or loss for each family:

Family	Weekly gain or loss (£)	Annual gain or loss (£) weekly gain x 52	Percentage gain or loss (%) annual gain as % of income
Employed single parent, one child, £9,000
Single-earner couple, two children, £12,000
Single-earner couple, two children, £17,000
Two-earner couple, two children, £50,000
Two-earner couple, two children, £100,000

Which family has lost the most as a percentage of their income?

Which family has lost the least as a percentage of their income?

Why may this be a disadvantage of using VAT and other indirect taxes as a tool of fiscal policy?

What other disadvantages might there be of using indirect taxes as a tool of fiscal policy in managing the economy?

Economists' views on whether fiscal policy should be used as a tool of economic management differ. Use the Library section of the Virtual Economy to find out the views of Keynesian and Classical economists on using fiscal policy to manage the economy. Write a brief summary of the views of each group.