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![Which businesses are likely to be most
affected by this increase in income tax
rates? Businesses which produce
luxury goods which consumers do not
have to buy are likely to be the most
affected. Businesses producing
essential goods and services will be less
affected. Consumers will still have to
buy these products.
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Government economic objective and policies
This chapter will explain government economic objectives like low inflation and unemployment, the business cycle stages, and fiscal and monetary policies that governments use to influence the economy. It will discuss how tax and spending changes and interest rate adjustments impact businesses and how firms can react. The chapter defines key terms and describes the main economic objectives, problems high inflation and unemployment cause, how economic growth benefits a country, the typical business cycle stages, and issues with a trade deficit. It also outlines how income, profit, VAT, and tariff taxes affect consumer spending and business activity.
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Government economic objective and policies
- 1. This chapter willexplain: • government economic objectives • the main stages of the business cycle • the tax and spending changes that governments can make • the interest rate changes that governments can make • the impact these changes have on businesses and how they can react to these changes.
- 2. Government economic objectives Mostgovernments have the following economic objectives: • low inflation • low unemployment • economic growth • balance of payments between imports and exports.
- 3. Low inflation Inflation occurswhen prices rise. Low inflation is an important objective. When prices rise rapidly it can be serious for the whole country. These are the problems a country will have if there is rapid inflation: • Workers’ wages will not buy as many goods as before. This means that people’s real incomes will fall. Real income is the value, in terms of what can be bought, of an income — if a worker receives a 6 per cent wage increase but prices rise by 10 per cent in the same year, then the worker’s real income has fallen by 4 per cent. Workers may demand higher wages so that their real incomes increase. • Prices of the goods produced in the country will be higher than those in other countries. People may buy foreign goods instead. Jobs in that country will be lost. • Businesses will be unlikely to want to expand and create more jobs in the near future. The living standards are likely to fall. Therefore low inflation can encourage businesses to expand and it makes it easier for a country to sell its goods and services abroad.
- 4. Definitions to learn Inflationis the increase in the average price level of goods and services over time. Unemployment exists when people who are willing and able to work cannot find a job. Economic growth is when a country’s Gross Domestic Product increases — more goods and services are produced than in the previous year. The balance of payments records the difference between a country’s exports and imports. Real income is the value of income, and it falls when prices rise faster than money income.
- 5. Low unemployment When peoplewant to work but cannot find a job, they are unemployed. These are the problems unemployment causes: • Unemployed people do not produce any goods or services. The total level of output in the country will be lower than it could be. • The government pays unemployment benefit to those without jobs. A high level of unemployment will cost the government a great deal of money. This cannot be spent on other things such as schools and hospitals. Therefore, low unemployment will help to increase the output of a country and improve workers’ living standards. High unemployment reduces output and can reduce living standards
- 6. Economic growth An economyis said to grow when the total level of output of goods and services in the country increases. The value of goods and services produced in a country in one year is called gross domestic product (GDP). When a country is experiencing economic growth, the standard of living of the population is likely to increase. When a country’s GDP is falling there is no economic growth. The problems this causes are: • As output is falling, fewer workers are needed and unemployment will occur. • The average standard of living of the population — the number of goods and services they can afford to buy in one year — will decline. In effect, most people will become poorer. • Business owners will not expand their firms as people will have less money to spend on the products they make. Economic growth, however, makes a country richer and allows living standards to rise.
- 7. Economic growth willmake a country richer and will allow living standards to rise
- 8. The business cycle Thebusiness cycle (sometimes known as the trade cycle) has four main stages, as shown on the diagram. A business cycle diagram
- 9. • Growth —this is when GDP is rising, unemployment is generally falling and the country is enjoying higher living standards. Most businesses will do well at this time. • Boom — this is caused by too much spending. Prices start to rise quicldy and there will be shortages of skilled workers. Business costs will be rising and firms will become uncertain about the future. • Recession — often caused by too little spending. This is a period when GDP actually falls. Most businesses will experience falling demand and profits. Workers may lose their jobs. • Slump — a serious and long-drawn-out recession. Unemployment will reach very high levels and prices may fall. Many businesses will fail to survive this period. Clearly, governments will try to avoid the economy moving towards a recession or a slump, but will also want to reduce the chances of a boom. A boom with rapid inflation and higher business costs can often lead to the conditions that result in a recession. Balance of payments Exports are goods and services sold by one country to people and businesses in another country. These bring money (foreign currency) into a country. Imports are goods bought in from other countries. These must be purchased with foreign currency so these lead to money flowing Out of a country. Governments will aim to achieve equality or balance between these over a period of time. The difference between a country’s exports and imports is called the balance of payments. If the value of a country’s imports is greater than the value of its exports then it has a balance of payments deficit. These are the problems that could result: • The country could ‘run out’ of foreign currencies and it may have to borrow from abroad.
- 10. Definitions to learn Recession— a period of falling Gross Domestic Product. Exports are goods and services sold from one country to other countries. Imports are goods and services bought in by one country from other countries. The exchange rate is the price of one currency in terms of another, for example El: $1.5. Exchange rate depreciation is the fall in the value of a currency compared with other currencies.
- 11. • The priceof the country’s currency against other currencies — the exchange rate — will be likely to fall. This is called exchange rate depreciation. The country’s currency will now buy less abroad than it did before depreciation. A balance of payments deficit can lead to major problems for a country
- 13. Activity 26.1 a) TheGDP of Country A was $500 million in 2010. The population was 1 million. The average income per person was therefore $500. By 2013, as a result of economic growth, GDP was $1500 million. The population had also risen to 2 million. What was the average income per person in 2013? b) Joe earned $20 000 in 2012. He had a pay rise of 10 per cent in 2013. Inflation was 15 per cent in 2013. i) How much did Joe earn in 2013? ii) Did his real income rise or fall in 2013? Explain your answer. c) For Country A, identify which of the following are imports or exports: i) washing machines purchased from Country B ii) cars made in Country A’s factories and sold to a garage in Country B iii) machines sold to Country A from Country B iv) tourists from Country B who spend two weeks on holiday in a hotel in Country A.
- 14. Government economic policies Governmentshave a great deal of economic power. They raise taxes and spend this money on a wide range of services and state benefits. It is not unusual for governments to have control over 40—50 per cent of a country’s GDP through the taxes they raise. Governments use this power to try to achieve the objectives we have just looked at. The decisions made by government can have a great effect on all businesses in a country. Business managers need to know how their firm could be affected by government economic decisions. The main ways in which governments can influence the economy — sometimes called economic policies — are: • fiscal policy — taxes and government spending • monetary policy — interest rates • supply side policies.
- 15. Fiscal policy: taxesand government spending All governments spend money. They spend it on schools, hospitals, roads, defence, and so on. This expenditure is very important to some businesses. For example: • construction firms will benefit from a new road building scheme • defence industries will gain if the government re-equips the army • bus manufacturers will benefit from government spending on public transport. Q: Where do governments raise this money from? A: Largely from taxes on individuals and businesses. Q: What are the main types of taxes? A: Direct taxes on the income of businesses and individuals and indirect taxes on spending. Q: How do these taxes affect business activity? A: In a number of different ways. We will look at these effects by studying the impact of four common taxes: • income tax • profits tax or corporation tax • indirect taxes, for example Value Added Tax (VAT) • import tariffs.
- 16. Income tax This isa tax on people’s incomes. Usually, the higher a person’s income the greater will be the amount of tax they have to pay to the government. Income tax is set at a certain percentage of income, for example 25 per cent of income. In many countries, income tax is progressive. This means that the rich pay tax at a higher rate than the poor. How would businesses be affected by an increase in the rate of income tax? Individual taxpayers would have a lower disposable income. They would have less money to spend and save. Businesses would be likely to see a fall in sales. Managers may decide to produce fewer goods as sales are lower. Some workers could lose their jobs.
- 17. Which businesses arelikely to be most affected by this increase in income tax rates? Businesses which produce luxury goods which consumers do not have to buy are likely to be the most affected. Businesses producing essential goods and services will be less affected. Consumers will still have to buy these products. ;1]
- 18. Definitions to learn Fiscalpolicy is any change by the government in tax rates or public- sector spending. Direct taxes are paid directly from incomes — for example, income tax or profits tax. Indirect taxes are added to the prices of goods and taxpayers pay the tax as they purchase the goods — for example, VAT. Disposable income is the level of income a taxpayer has after paying income tax.
- 20. Activity 26.2 Here areeight products: • bread • petrol • TVs • foreign holidays • cooking oil • jewellery • salt • home computers. The sales of four of these products are likely to fall following an increase in income tax rates. Sales of the other four will not be much affected. Identify the four products likely to be most affected.
- 21. Profits tax (orcorporation tax) This is a tax on the profits made by businesses — usually companies. How would an increase in the rate of corporation tax affect businesses? There would be two main effects. • Businesses would have lower profits after tax. Managers will therefore have less money or finance to put back into the business. The business will find it more difficult to expand. New projects, such as additional factories or shops, may have to be cancelled. • Lower profits after tax is also bad news for the owners of the business. There will be less money to pay back to the owners who originally invested in the business. Fewer people will want to start their own business if they consider that the government will take a large share of any profits made. Companies’ share prices could fall. INDIRECT TAXES Indirect taxes, such as Value Added Tax (VAT), are added to the prices of the products we all buy. They obviously make goods and services more expensive for consumers. Governments often avoid putting these taxes on really essential items, such as food, because this would be considered unfair, especially to poorer consumers.
- 22. • Prices ofgoods in the shops would rise. Consumers may buy fewer items as a result. This will reduce the demand for products made by businesses. • As prices rise so the workers employed by a firm notice that their wages buy less in the shops. It is said that their real incomes have declined. Businesses may be under pressure to raise wages, which will force up the costs of making products. Import tariffs and quotas Many governments try to reduce the import of products from other countries by putting special taxes on them. These are called import tariffs and they raise money for the government. Many international organisations, such as the World Trade Organisation, are trying to reduce the number of governments which do this. How would businesses in a country be affected if the government put tariffs on imports into the country? There are three possible effects.
- 23. • Firms willbenefit if they are competing with imported goods. These will now become more expensive, leading to an increase in sales of home-produced goods. • Businesses will have higher costs if they have to import raw materials or components for their own factories. These will now be more expensive. • Other countries may now take the same action and introduce import tariffs too. This is called retaliation. A business trying to export to these countries will probably sell fewer goods than before. Another method a government can use to limit imports is to introduce an import quota or physical limit on the quantity of a product that can be brought in. Quotas can be used selectively to protect certain industries from foreign competition that may be seen as unfair or damaging to jobs. Changes in government spending Governments in most countries spend the tax revenue they receive on programmes such as: • education • health • defence • law and order • transport — roads and railways.
- 24. Definitions to learn Animport tariff is a tax on an imported product. An import quota is a physical limit to the quantity of a product that can be imported.
- 25. MONETARY POLICY —INTEREST RATES An interest rate is the cost of borrowing money. In most countries, the level of interest rates is fixed by the government or the central bank via monetary policy. In some societies, the charging and the payment of interest is against the customs and traditions of the population. In most countries, however, businesses and individuals can borrow money, from a bank for example, and they will have to pay interest on the loan. The following are likely to be the main effects of higher interest rates. • Firms with existing variable interest loans may have to pay more in interest to the banks. This will reduce their profits. Lower profits mean less is available to distribute to the owners and less is retained for business expansion. • Managers thinking about borrowing money to expand their business may delay their decision. New investment in business activity will be reduced. Fewer new factories and offices will be built. Entrepreneurs hoping to start a new business may not now be able to afford to borrow the capital needed. • If consumers have taken out loans such as mortgages to buy their houses, then the higher interest payments will reduce their available income. Demand for all goods and services could fall as consumers have less money to spend.
- 27. Definitions to learn Monetarypolicy is a change in interest rates by the government or central bank, for example the European Central Bank. Exchange rate appreciation is the rise in the value of a currency compared to other currencies
- 29. SUPPLY SIDE POLICIES Inrecent years many governments have tried to make the economy of their country more efficient. They aim to increase the competitiveness of their industries against those from other countries. This would allow their businesses to expand, produce more and employ more workers. Some of the policies which have been used to achieve these aims are listed below — they are called supply side policies because they are trying to improve the efficient supply of goods and services. • Privatisation — privatisation is now very common. The aim is to use the profit motive to improve business efficiency. • Improve training and education — governments plan to improve the skills of the country’s workers. This is particularly important in those industries such as computer software which are often very short of skilled staff. • Increase competition in all industries — this may be done by reducing government controls over industry or by acting against monopolies.
- 30. 26.3: IMPACT OFECONOMIC POLICIES You are the Managing Director of the largest computer manufacturing company in your country. Your business sells products at home and in foreign markets. Materials are imported from abroad. You employ hundreds of skilled workers to develop, assemble and test the computers. Your business is planning a major expansion programme. The government of your country has recently announced the following policies. Explain the likely impact of each of these policies on your business: a) a reduction in income tax rates on high income earners b) lower corporation tax rates c) higher import tariffs on all imports d) higher interest rates e) higher expenditure taxes on luxury goods f) new training colleges to increase the supply of qualified workers g)strict controls on monopoly businesses to encourage new businesses to be formed.
- 32. Case study —Spanish people protest over economic policies Huge protests have taken place in Spain as people and business leaders voice their worries over the government’s economic policies. The Spanish Government’s finances are deeply in debt so it is having to cut government spending and increase direct and indirect taxes. The country’s GDP fell last year and is expected to decline again in 2013. Living standards are falling — especially amongst the growing numbers of unemployed. About 23 per cent of the total workforce are now unemployed.
- 33. Activity 26.4 Read thecase study above. a)Explain what is meant by ‘the country’s GDP fell last year’. b)Explain how falling living standards could affect: • a farm producing milk • a manufacturer of luxury leather goods. c) Identify and explain two reasons why the Spanish government might aim to reduce the level of unemployment.