Fiscal Policy - Fiscal Policy as a Supply-side Tool

Supply-side policies are policies that aim to increase the capacity of the economy to produce (i.e. shift AS).

Fiscal policy usually acts on the level of demand in the economy, such as deflationary and reflationary policies, often known as demand-side policies. However, it is also possible for fiscal policy to act on the level of supply as well.

Income tax will always have an effect on people's incentives to work. This will be true at most income levels. If income tax at low income levels is too high, people may choose not to work but to remain on benefits instead. If income tax on high levels of income is too high, people may choose not to work so hard and take risks. Ultimately they may even choose to leave the country if taxes elsewhere are much lower (a "brain drain").

Supply-side fiscal policies could therefore include:

• Cutting the lower and basic rates of tax to open up the gap between earnings in and out of work and ensure people have an incentive to work
• Increasing the level of personal allowances for the same reason
• Reducing the top rate of tax to encourage enterprise, risk-taking and the incentive to work hard

Taxation and Work Incentives

Can changes in income tax affect the incentive to work? This remains a controversial subject in the economic literature.

Consider the impact of an increase in the basic rate of income tax or an increase in the standard rate of national insurance contributions. The rise in direct tax has the effect of reducing the post-tax income of those in work. For each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income.

Conversely, the effect might be to encourage less work since the tax might act as a disincentive to work. Of course many workers have little flexibility in the hours that they work. They will be contracted to work a certain number of hours, and changes in direct tax rates will not alter that.

The government has introduced a lower starting rate of income tax for lower income earners. This is designed to provide an incentive for people to work extra hours and keep more of what they earn. Changes to the tax and benefit system seek to reduce the risk of the poverty trap – whereby households on low incomes see little net benefit from supplying extra hours of labour in their work.

If tax and benefit reforms can improve work incentives and lead to an increase in the labour supply, this will help to reduce further the equilibrium rate of unemployment, and thereby increase the economy’s non-inflationary growth rate.

Taxation and Labour Productivity

Some economists argue that taxes can have a significant effect on the intensity with which people work and their overall efficiency and productivity. But there is little substantive empirical evidence to support this view. Many factors contribute to improving productivity – tax changes can play a role, but isolating the impact of tax cuts on productivity is extremely difficult.

Taxation – Investment and Long Run Aggregate Supply

Lower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital investment spending. If planned investment increases, the nation’s capital stock can rise and the capital stock per worker employed can rise.

The government might also use tax allowances to stimulate increases in research and development and encourage an increase in the rate of small business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct investment – a stimulus to the economy that might benefit both aggregate demand and supply.

Investment can also be seen beyond purchase of new machines.

Changes to the tax system and specific areas of government spending might also be used to stimulate investment in technology, innovation, the skills of the labour force and social infrastructure. A good example of this might be a substantial increase in real government spending on the transport infrastructure. Improvements in our transport system would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness.

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