Question: Evaluate the impact of a rise in income tax.
A rise in income tax will likely lead to a more equal distribution of income. An increase in income tax rates should make income tax more progressive, so the richer you get the more income tax you pay in percentage terms. Income distribution becomes more equal because the rich pay even more income tax than the poor in terms of the percentage of their income, so the Gini coefficient will fall. Also, the government could use the increased tax revenue from taxing the rich more to subsidise poor families to decrease inequality and the Gini coefficient even further.
However, the rich may be incentivized to pay for accountants to find loopholes and dodge paying the higher tax rates. Furthermore, the rich may divert their savings towards foreign tax havens to avoid paying increased taxes in the UK. More tax avoidance (legal) and tax evasion (illegal) will occur. Additionally, increased taxes may decrease AD and lead to job losses for the lowest paid workers. So income distribution may not become that much more equal.
Also, a rise in income tax may lead to higher unemployment. An increase in income tax rates means people get less disposable income from working because their after-tax wage is lower, this disincentivizes people from working. Unemployment will rise because the unemployed have even less incentive to enter the work force and some workers quit their jobs if unemployment benefits give them more than wages. Moreover, the higher tax rates will discourage workers from working over-time or seeking promotion because their net pay is lower than before the tax hike.
But, the government may also increase the tax-free allowance at the same time, this will encourage the low income workers to remain employed and may encourage the unemployed to enter the work force. Also, workers seeking promotion may continue to do so anyway because their disposable income still rises even if tax rates rise.
Additionally, higher income tax may decrease economic growth. An increase in income tax rates may decrease economic growth. An increase in income tax means disposable income falls, consumers have less money to spend so consumption falls, AD falls and real GDP falls. Additionally, if an increase in income tax disincentivizes people from working then labour hours fall, the PPF shifts left and real GDP falls. Furthermore, firms may be discouraged from investing because consumers have less disposable income, so investment falls, AD falls and real GDP falls further. Multiplier effects mean AD and real GDP will fall even further. There is an increase in leakages and a fall in injections and the economy may fall into a recession.
The extent of the fall in real GDP depends on the magnitude of the rise in income tax rates. A large rise in income tax rates will decrease disposable income, consumption, AD and real GDP significantly. Also, the more elastic are AD and LRAS, the larger the fall in real GDP.
Lastly, a rise in income tax may lead to higher tax revenue. An increase in income tax rates should increase the government’s tax revenue. As income tax rises, workers pay a higher proportion of their income in tax so the government receives more tax revenue. This gives the government more funds to increase spending on health and education to increase the economy’s efficiency and shift LRAS right.
Although, the Laffer curve suggests that an increase in income tax rates may decrease the government’s tax revenue. Income tax may already be at such a high degree that any further increase in income tax means a significant amount of workers will quit their jobs because their after-tax wage is too low, they would rather go on benefits.