Professional's Academy of Commerce IEF (CAF-02)

Chapter 9: Growth and Taxes

9.1. Economic Growth

Economic growth is a long-term expansion of a country’s production potential.

9.1.a. Objectives of Growth

Advantages:
Higher living standards: An increase in the real income of the individuals in an economy.
Employment effects: With economic growth, the capacity in an economy increases and therefore there is more
opportunity for employment within society.
Fiscal benefits: With higher GDP growth, firms and individuals will increase the amount of taxes that they pay.
This gives government better opportunity to meet their objectives.

Disadvantages:
Environmental concerns: Fast growth may be at the expense of the natural environment. This has been
attributed to the swathes of deforestation in many rural areas of the world, as the wood has been used to fuel
economic growth.
Inequality: There is also an argument that economic growth merely exacerbates inequality that is present in an
economy. Whilst it might reduce absolute poverty, the level of relative poverty in countries may increase
dramatically with a drive for economic growth.
Inflation risk: If demand outstrips supply due to rising incomes then, as we have seen, there is the risk that
demand-pull inflation will set in, causing the general price level to increase to an unsustainable level.
Working hours: With an increased economic output, there are concerns that workers may be exploited,
working longer hours than they should. This might upset work-life balance, leading to social problems.

9.1.b. Benefits of Growth

Higher Employment: Real economic growth gives rise to higher employment. An outward shift in the
aggregate demand for labour would be seen due to an increase in the real GDP. This is because with higher
levels of output firms tend to employ more workers.
Increased tax revenues: Growth boosts the government finances by way of taxes that in turn helps to reduce
the budget deficit. The extra money would be used to finance productive projects.
Enterprise confidence: Sustained economic development casts a positive impact on company profits and raises
business confidence.
Increased per capita income and improved living standards: Sustainable economic development improves
the living standards of the community, reduces poverty and raises per capita income.
Higher investment: Economic growth induces demand that in turn leads to higher level of investments due to
the likelihood of more profits.
Social welfare: Increased economic growth raises the scope of welfare activities. Government has now more to
spend for supporting elderly, homeless and orphaned people.

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9.1.c. Costs of Growth

Inflation: In case Aggregate Demand races ahead of Aggregate Supply then the resultant economic growth
would not be sustainable. It is a condition that many fast-growing countries have witnessed, where demand
increased too quickly that they got a positive output gap and firms pushed up the prices.
Negative externalities: Rapid growth can give rise to plenty of environmental concerns; it might include noise
pollution, air pollution, road congestion, household and industrial waste, deforestation etc.
Current account deficit: Economic growth causes an increase in spending on imports and consequently a
deficit on the current account is caused.
Inequality: More often increased rates of economic growth result in an increased level of inequality because
the growth may benefit a small section of the society more than the others.

9.2. Business Cycles

The patterns of output fluctuations are known as business cycles. Though no cycle will be identical, there are
distinct phases in each which one can analyse, recognise, and therefore use an indicator for future events. It has
been observed throughout economic history that there is often an upwards trend in the level of economic
growth. Peaks and troughs form, but after each cycle, the level of Real GDP is greater than before.

Prosperity (Boom period): The economy is expanding, meaning output, income, employment, prices and
profits should all increase. At this stage, banks issue credit more freely which facilitates firms to invest in
increasing output to meet the demands of consumers with higher income. Output grows, as does overall
business optimism. A growing economy also means that there may be inflationary pressures, caused by high
demand, and insufficient levels of output. To temper these pressures, central banks are likely to increase interest
rates. As output increases and increases, there comes a point where it can expand no further, which is when the
cycle reaches its peak.
Downturn: At this stage, economic activity begins to slow down. When demand begins to decrease, firms
begin to scale back their production and investment plans. There is a steady decline in output, profits, prices and
employment as demand falls, and firms respond by reducing their output. Banks reduce the credit they issue,
firms cancel orders that they place, and people begin to lose their jobs, which further decreases the level of
aggregate demand.
Recession/depression: With unemployment levels high, incomes low, consumer demand low and investment
low, the economy slips into a state where output remains very low. There is an under-utilisation of resources as

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machinery lies dormant. Business confidence is extremely low, as profits and prices go lower and lower.
Economic activity is at its lowest, meaning the business cycle is at its trough.
Recovery: From the low point, there is an increase in levels of economic activity as demand begins to increase
slightly. With an increase in demand, production increases, causing an increase in investment. This causes a
steady rise in output, incomes and business confidence. This leads to an increase in investment, somewhat
helped by banks increasing credit. Assets in the economy begin to be utilised again, and levels of GNP increase
once more.

9.2.a. Indicators of Growth and Recession

a. Leading Economic Indicators: The nature of these indicators is that they are used to forecast at what stage
the economy will be in, at some time in the future. These in particular give an indication for whether a peak or
trough will be reached in the following 3-12 months.
• Index of business confidence
• Manufacturers’ new orders
• New building permits for private housing
• The money supplies
b. Coincident Economic Indicators: These indicators are events and measures that occur at the same time as a
peak
or trough occurs. They are used by governments to assess at what stage in the cycle the economy is in.
• Number of people in employment
• Industrial production
• Personal incomes
• Manufacturing and trade sales
c. Lagging Economic Indicators: These indicators are used to assess whether an economy has reached a peak
or trough 3-12 months after it would have occurred.
• Consumer Price Index (i.e. level of inflation)
• Average duration of unemployment
• Interest rates
• Average income

9.3. Fiscal Policy

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and
influence a nation's economy. Policies undertaken by a government to influence macroeconomic conditions, and
therefore economic activity, through the use of taxation and spending.

Expansionary policy: A macroeconomic policy that seeks to increase the rate of economic growth. An
expansionary policy can be applicable not just to fiscal policy, but also for monetary policy. Nevertheless, in
this case there are a number of policies that a government can undertake to boost the rate of economic growth
such as:
• Tax cuts
• Tax rebates
• Increased government spending

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Contractionary policy: A macroeconomic policy that seeks to slow down the rate of economic growth. If an
economy is suffering from high inflation, it may be that the country’s financial department looks to halt the high
level of growth that occurs. This can be done through some of the following policies:
• Increase taxes
• Reduce subsidies
• Wage freezes

9.3.a. Objectives of Fiscal Policy

Keep inflation low: Ensuring the price level remains stable avoids persistent problems throughout the
economy.
Keep employment high: Governments have a social objective to ensure high levels of employment.
Steady economic growth: Most economists agree that consistent, gradual economic growth is favourable.
Equilibrium in Balance of Payments: This ensures that the value of a country’s imports and exports are equal.
Run a balanced budget: Meaning whatever the government spends, it can pay for.

9.3.b. Limitations of Fiscal Policy

Forecasting: The fiscal policy is devised around predictions of various economic activities. For the fiscal
policy to work as desired, these predictions need to be accurate. This however is a practical difficulty where the
coming events of economic instability cannot be predicted accurately. Unless the amount of revenue,
expenditure and budget balance could be analysed, policy cannot be suitably planned.
Time lag: In general, there exists a time lag where an action is needed and the time when the fiscal measure has
its impact felt. The interval in between determines the extent of the effectiveness of the measure undertaken.
Crowding out: Increased government spending for stimulating aggregate demand might result in crowding out;
that refers to decreasing the size of private sector due to increased government spending.
Tax: Raising taxes in order to reduce Aggregate Demand may cause demotivation to work. Consequently, a fall
in productivity might be observed and Aggregate Supply may fall.
Public sector finances: An important part of how the macro economy is run is how the government pays for
the policies that it must implement. The money that it spends on projects is often not within its possession
initially, and so it must borrow in order to pay for them.

9.4. Sources of Public Sector Borrowing

The main way that a government will finance itself is through issuing sovereign bonds, T-Bills, or other
financial instruments. In simple terms, it receives money now from investors and in exchange must pay them
back at a future date. This gives governments liquidity and allows them to finance their work. This is, however,
classified as a debt for the country. It is based upon the assumption that the government will pay back the holder
of the bond at the prescribed future date.
• National Debt: The levels of national debt can become an indication of a country’s financial stability. If
it is unable to meet the obligations that it has to its investors, then it is likely that a debt crisis may ensue,
whereby investors become less confident that they will receive their money back, and so ask for a higher
premium which increases the cost of borrowing for governments making it more difficult to implement
policies.
• Public Debt: This is the accumulation of not only the national debt that the government has, but also the
total amount of debt held by the public (consumer debt, credit debt, mortgage debt).

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9.5. Tax
A tax is a compulsory financial charge or some other type of levy imposed upon a taxpayer (an individual or
legal entity) by a governmental organization in order to fund various public expenditures.

9.5.a. Functions of Taxation

Fiscal: Taxes form the budget from which governments can allocate resources across the economy.
Allocation: It acts as a means of distributing wealth between various groups of citizens: wealthy to poor, as a
means of maintaining a social stability.
Regulatory: Ways of changing the behaviour of individuals or firms through imposition of taxes.
Incentive: Stipulating special tax arrangements for certain members of society as a result of past achievement.

9.5.b. Types of Taxes

Regressive taxes: A tax where lower income entities pay a higher fraction of their income than higher income
entities.
Proportional taxes: A tax where everyone, regardless of income, pays the same fraction of income in taxes.
This is also known as a “flat tax”.
Progressive taxes: A tax where higher income entities pay a higher fraction of their income than lower income
entities.

9.5.c. Characteristics of a Good Tax

Efficiency: A tax should raise revenue without creating negative distortions in the economy, such as
disincentives to work and invest.
Equitable: Taxes should be paid based upon someone’s ability to pay.
Benefit principle: A principle whereby people should pay taxes based upon the utility that they gain from its
implementation.

9.5.d. Canons of Taxation

The canons of taxation refer to the qualities that a good taxation system must possess. These are in fact
associated to the administrative aspect of the tax system.
Canon of Equality: “The subjects of every state ought to contribute towards the support of the government, as
nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue which they
respectively enjoy under the protection of the state.”
Equality or justice is the most imperative canon of taxation. It means that the tax paid should be in proportion to
the ability of the tax payer i.e. the amount of revenue.
Canon of Certainty: “The tax which each individual is bound to pay ought to be certain, and not arbitrary. The
time of payment, the manner of payment, the quantity to be paid ought all to be clear and plain to the
contributor and to every other person.”
All the tax payers should be informed as to why and when they have to pay a particular sum of tax which is why
tax budgets are given so much publicity and transparency. There should not be a single element of uncertainty
in a tax.
Canon of Convenience: “Every tax ought to be levied at the time or in the manner in which it is most likely
to be convenient for the contributor to pay it.”

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The time and manner of payment should be convenient. Tax on land is to be paid along with the rent due.
Similarly, consumer taxes are paid when consumers purchase a good or service as the tax is included in the
price of the commodity.
Conon of economy: “Every tax ought to be so contributed as both to take out and to keep out of pockets of the
people as little as possible, over and above what it brings into the public treasury of the state.”
Tax is economical when the cost of collecting it is small and when the amount of tax collected is equal to the
treasury which means no amount gets lost in the middle of the tax collection process. A tax is also economical
when it does not hamper the economic progress of the country. While heavy taxes on income discourage
savings, taxes on harmful drugs and intoxicants are considered economical. Whereas, tax on raw materials is
considered uneconomical because it increases the prices of manufactured goods.
Other canons
Fiscal adequacy or Productivity: Taxes should be such that the government is able to meet the expenses with
the taxes collected by the citizens. However, the economic resources of the country or the productive capacity
of the community should not be sacrificed to gain excess tax revenue.
Elasticity: Elasticity is another canon which means that the tax revenues should increase as the state
expenditure increases. Also, when in the case of emergency, the state should be able to augment its financial
resources.
Flexibility: The tax system should not be rigid which means it should be able to adjust to changing conditions.
Moreover, simplicity is another rule which states that the system of taxation should be simple enough for
everyone to understand without which corruption or oppression might prevail because it would be too
complicated for the common man and the power will go to the tax gatherers.
Diversity: There should be diversity in taxes which means there should be a large variety of direct and indirect
taxes so that every citizen who is able to pay can do so.
Social and Economic Objectives: Finally, the effects of taxation should be compatible with the social and
economic objectives of the community such as accelerating economic growth and reduction of inequalities of
income and wealth.

9.5.e.1. Direct Taxation: A tax paid directly to the government by the person on which it was imposed.
Advantages
Equitable: people with higher income pay more into society than those with less income, creating a more
equitable distribution of (net) wealth.
Cost of collection is low: meaning it is an economical way of raising revenue, saving expense.
Relative certainty: the government can estimate how much it will receive allowing better planning of projects.
Flexible: if a government needs to raise revenues quickly, it can do so by
raising direct taxes.
Disadvantages
Possible to evade: it is possible to falsify tax claims meaning the correct amount is not always paid.
Unpopular: it is very obvious when a direct tax is being paid meaning the end user will often try to find ways
to avoid paying it.
Discourage savings/ investment: if too high, then it would leave consumers and firms less money to put to
other causes that could reap reward.

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9.5.e.2. Indirect Taxation: A tax that increases the price of a good, meaning the tax is paid when the good is
bought.
Advantages
Change the pattern of demand: the government can alter the demand for a product (say, alcohol or cigarettes).
Can correct externalities: if a product causes direct external costs (e.g. health costs associated with alcohol or
cigarettes), the tax can be used to mitigate these.
Less easy to avoid: often these are part of the final price, ensuring taxes are paid.
Allows people greater choice: consumers make choices and then tax is paid, rather than having income taken
away immediately.
Disadvantages
Increases inequality: regardless of income, people are still faced with the same tax on a good
Cause cost-push inflation: by increasing the price of inputs for goods.
Establish a “black market”: if taxes make prices too high, can incentivize people to source the goods from
alternate (sometimes illegal) markets.
Higher uncertainty: if in a recession, people are buying less goods, then this means the revenue received will
decrease much more.
Distorts the market: can lead to disequilibrium in the market for products that have been taxed.

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