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Government Tax Rates during a Recession

Moldova has a population of 3.5 million. It is one of the poorest countries in Europe, with relatively low living standards. In 2015, the country experienced a recession and a doubling of its inflation rate. Moldova’s central bank increased its interest rate from 8.5% to 15.5%.

Discuss whether a government should increase tax rates during a recession. [8]

Category:

Public Finance and Government Intervention

[CIE O level]

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Answer


Step 1 : Define ‘tax’ and ‘recession’ in the introduction.

Taxation is the method by which governments finance their spending by levying charges on their citizens and business entities in order to generate revenue. A recession is a macroeconomic term that refers to a significant decline in general economic activity in a country that goes on for more than a few months. Several points must be considered before deciding to increase taxes during a recession.


Step 2 : Discuss how an increase in tax can help an economy during a recession.

An increase in tax may help an economy in recession in several ways.

The higher tax revenue could be used to implement policies to stop the recession. The government may be able to raise more tax revenue to spend on supply-side policy measures such as education and training. This would increase unemployment and boost the economy

A higher import tariff may encourage some consumers to switch from foreign products to buying domestic products. This would create employment in the country and boost economic growth.

The government may want to redistribute income. Progressive taxes could be increased and this tax revenue could be used to help the poor who may be particularly harmed by a recession.


Step 3 : Discuss how an increase in tax can be a disadvantage to an economy during a recession.


Taxes should not be increased in a recession for the several reasons.

Higher tax rates may reduce disposable income. This will result in a fall in consumer expenditure and reduce investment. Lower consumer expenditure and investment would lower total demand this may reduce output further. This is shown in the diagram below.

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An increase in taxes means that an increase in taxes will mean that consumers and business will have less money in hand, there will be a fall in aggregate demand for AD to AD1 . There will be a fall in output from Y to Y1. This could worsen the recession.

Higher tax rates may discourage MNCs from setting up in the country this may mean it will take longer to get out of a recession.

Increased taxes can put negative pressure on investment. When taxes are increased, businesses may have a more difficult time making profits, which can cause investors to pull out of the market after a tax hike.

Higher tariffs may provoke retaliation to reduce both imports and exports and this may worsen the recession. Tariffs also raise the price of imports. This impacts consumers in the country applying the tariff in the form of costlier imports. When trading partners retaliate with their own tariffs, it raises the cost of doing business for exporting industries.

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Step 4 : Conclude whether taxation should be increased.
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To conclude, taxation can be effective during a recession to raise revenue to finance supply-side policies. Tariffs can help consumers switch from foreign products to local products. This will help boost the economy. However, the effects of an increase in taxation on consumer spending and aggregate demand should be taken to account. An increase in taxation can reduce aggregate demand and worsen a recession.

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