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Who Will Pay For Covid - The Implications Of Tax Increases In Macroeconomics

By: CIFER Updated, Feb 22nd, 2021

Government's around the world have stepped up to cover the financial fallout during lockdowns, giving business grants, loans and taking on the payroll of a large portion of the working population. Government policy has kept economic activity primed for a rapid recovery, however, it will likely come at a cost to the taxpayer. Several countries have proposed that the increases in government debt to be recouped via tax increases. The BOE announcing several tax measures for corporations alongside government cuts will allow the spiralling covid debt to be tamed. Similarly in the US, President Biden's reformed tax policies focused on the wealthy, will help pay for the $2 Trillion stimulus package needed to restart the economy. 

Some economists believe that reducing taxes is more beneficial in attempts to boost economic growth, as it gives households and businesses higher disposable income for either consumption or reinvesting. The multiplier effect would take control as unemployment drops, and there is a higher volume of tax payers in the economy, albeit at a lower rate. However, with the economic state post covid, its is more dubious to expect this as the levels of government and personal debt has risen drastically - therefore increased government income would unlikely be spent on public spending but rather deficit control, likewise for households. So this takes us back to the possibility of tax increases and how that would play out over the coming years.


Economic Theory (IS/LM) - How The Money Flows

Theoretically, tax increases can come in either a marginal rate tax or a lump sum tax increase. The difference between the two is as simple as it sounds, one is measured as a proportion of income and one is a lump sum, regardless of income levels. The implications in the goods and money markets vary depending on which measure is put into practice. Firstly let's take a look at increases in lump sum tax and the effects it can have on households. 

Increasing tax rates increases leakages in the circular money flow as 1) household disposable income drops 2) Spending power of disposable income drops as goods increase in price (VAT/ Duty increases) therefore the overall effect is a drop in consumption and aggregate expenditure. As a result, aggregate demand in the economy falls therefore although the lump sum tax boosts government income initially, the fall in output will outweigh the rise in tax increases in the short run. In particular with the case of Covid where tax increases will be put towards debt repayments rather than increasing public spending, over aggregate demand will likely rebalance at a lower level. 

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In the long run, the connection with the goods and money markets rebalances the economy at equilibrium. As income fell, the demand for money followed, thus creating excess money supply in circulation. For this to be rectified and the money market to return to equilibrium, interest rates must drop. However, with cheap interest rates comes incentives to borrow, boosting investment once again.

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The shift to A is temporary until the money market adjusts and the economy settles again at E1 and the money and goods markets rebalance; shown from the graph above, a lower level of income than pre tax cut levels of E0. Therefore, using the IS/LM model we can see that lump sum tax increases have a negative effect on government income as the slowing economic growth outweighs the increases in tax revenues. 


The result is very similar for changes for marginal rate tax as for lump sum tac however, graphically there are differences. The IS curve does not move parallel but rather rotates inwards and steepens off the same horizontal axis point. Graphically this represents the impact of the shock proportional to income. Ultimately the new equilibrium is the same position with a lower interest rate and lower level of income than pre shock. 


According to which economist you ask, tax changes will have different outcomes on the economic data. The response to tax reforms rely heavily with consumer preferences/ consumption choices and the elasticity of demand. Arguments also lie in the labour market as to what lower disposable income to do to preferences of the work force.

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