(2021) A Level H2 Econs Paper 2 Essay Q4

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4. The rate of unemployment in more than 50 of the world’s countries, including several European countries, exceeds 10%. Governments face a difficult decision about whether income tax rate cuts are the most effective policy to reduce unemployment to more acceptable levels.

(a) Explain how a reduction in the rate of income taxes paid by workers and firms might have consequences on an economy’s aggregate demand and aggregate supply. [10]

Impact of fall in income taxes paid by workers on AD & AS 

 Increase in disposable income 

1. A reduction in the rate of income taxes paid by workers will increase the disposable income of workers 

2. The increase in disposable income will increase → increase Consumption → increase AD 

Comment: I’m well aware that many schools will actually not accept this with the reasoning that an increase in incomes affects income-induced Consumption and not autonomous Consumption and thus wouldn’t shift AD. 

Conventionally, in many textbooks / universities where this is taught, this is actually accepted (increase in disp Y → increase C → increase AD)  

So my stand here is that I would be accepting this too (besides there’s just too many ways to bypass this anyway, by focusing on optimism, or the fact that this is a government policy factor and not an organic increase in incomes) 

 

Increase in incentive to work 

1. A reduction in the rate of income taxes paid by workers will give workers a greater incentive to put in more hours / effort at work. More workers may also be willing to enter the workforce. 

2. This increases the productive capacity → increases LRAS 

 

Impact of fall in income taxes paid by firms on AD & AS 

Investments become more profitable 

1. As income taxes for firms decreases, investments become more profitable, giving firms an incentive to increase investments / attracts a higher level of inward investment 

2. Investment increases → increase AD 

 

Firms invest more 

1. As firms invest more in capital goods → capital stock in the economy increases, increases the ability of the economy to produce goods and services 

2. Productive capacity of the economy increases → LRAS shifts right 

 

Illustration of rightward shift of AD and rightward shift of LRAS to be shown on diagram (separately or in a single diagram, both are ok) 

(b) Discuss whether a reduction in the rate of income taxes is likely to be the best policy measure to reduce high unemployment in a country. [15]

Introduction 

• Unemployment is described as a situation in which a worker is willing to work, actively finding work but cannot find work. 

• Unemployment is considered to be high if significantly above the natural rate of unemployment (2-3% for small economies / 3-5% for large economies) 

 

How reduction in rate of income taxes reduce high unemployment 

Explain expansionary fiscal policy 

1. A reduction in the rate of income taxes paid by workers will increase the disposable income of workers 

2. The increase in disposable income will increase → increase Consumption → increase AD → real NY income increases → higher economic growth → firms hire more factor inputs including labour → fall in cyclical unemployment 

3. As income taxes for firms decreases, investments become more profitable, giving firms an incentive to increase investments / attracts a higher level of inward investment 

4. Investment increases → increase AD → real NY income increases → higher economic growth → firms hire more factor inputs including labour → fall in cyclical unemployment 

 

Is it likely to be the best policy measure 

1. For a country facing high unemployment, cyclical unemployment is usually one of the key causes of unemployment → expansionary fiscal policy should be helpful to some extent in increasing AD to stimulate the economy and increase demand for goods & services, creating also demand for jobs 

2. For countries with high levels of public debt, expansionary fiscal policy may end up worsening budget position, causing public debt to increase → future interest payments will go up leading to increased burden for future generations. This is true in the case of Japan where public debt is at 266% of GDP. 

3. Given the likelihood of multiple causes and types of unemployment present in situations of high unemployment, expansionary fiscal policy alone would unlikely be the best policy measure to reduce high unemployment in a country 

 

Monetary policy as an alternative 

1. As an alternative to fiscal policy, countries can consider expansionary monetary policy 

2. Increase money supply → fall in interest rates → Households find it cheaper to borrow to buy large ticket items / more investments become profitable at a lower interest rate → increase C & I → increase AD → increase real NY → higher economic growth 

3. Firms will hire more factor inputs like labour to increase the level of output → fall in cyclical unemployment 

4. Monetary policy can be a more ideal policy as an alternative to fiscal policy especially if country already has very high public debt 

5. However if interest rates start to approach zero (liquidity trap), monetary policy can become less effective - like what happened in U.S. in both addressing with Global Financial Crisis & in the covid-19 pandemic where they had to resort to the use of quantitative easing in addition to conventional monetary policy 

 

Supply side policy as an alternative 

1. Both monetary and fiscal policy are demand management policies addressing cyclical unemployment. They however, do not address structural and frictional unemployment which both tend to be present in economies with very high unemployment. 

2. Supply side policies can be targeted at addressing structural unemployment. Structural unemployment occurs when there is a mismatch between jobs available in the economy and skills of workers who are unemployed 

3. The government can provide subsidies for affected workers to undergo re-training, to be re-trained especially in parts of the economy where jobs are readily available. 

4. Training however, can take time and such subsidies can be very costly to provide and thus subject to the size of the country & budget position. 

 

Conclusion 

1. Due to the likelihood of multiple types / causes of unemployment when unemployment is very high, a single policy such as expansionary fiscal policy would unlikely be the best policy. 

2. There is no ‘best policy’ - a combination of policies should be deployed depending on the specific causes of unemployment & any limitations faced in deploying such policies specific to the country’s context 

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