Taxation and Government Expenditure (Edexcel A-Level Business): Revision Notes

Taxation and Government Expenditure

Understanding fiscal policy

Governments use fiscal policy to influence business decisions and overall economic activity. This policy tool involves adjusting taxation levels and government spending to manage the economy. Fiscal policy is a key macroeconomic instrument that can either stimulate growth during downturns or cool down an overheating economy.

When the government changes taxes or spending, it directly affects businesses and consumers. These changes ripple through the economy, influencing demand, costs, investment decisions, and overall business performance.

Taxation in the UK

The UK tax system consists of various taxes paid by both businesses and individuals. These taxes can be classified into two main categories: direct taxes and indirect taxes.

Direct taxes (taxes on income)

Direct taxes are charged on income and profits. The main direct taxes include:

Income tax is paid on personal income from employment and self-employment. Changes in income tax rates or personal allowances directly affect how much disposable income consumers have available to spend on goods and services.

National Insurance contributions are paid by both businesses and individuals based on employee earnings. Employers pay National Insurance on their employees' wages, which increases their labour costs.

Corporation tax is paid by companies on their profits. This tax directly reduces business profits and can influence investment decisions and dividend payments to shareholders.

Capital gains tax is charged on the profit made when selling assets such as property or shares. This tax can affect investment behaviour and shareholder decisions.

Inheritance tax is paid when money or assets are transferred to another individual, typically after death. Changes in inheritance tax can affect consumer spending patterns, particularly among older, wealthier demographics.

Indirect taxes (taxes on spending)

Indirect taxes are charged on spending and consumption. The main indirect taxes include:

Value Added Tax (VAT) is paid on most goods and services, with some exceptions like basic food items. VAT increases the final price paid by consumers and adds to business costs when they purchase supplies.

Excise duties are charged on specific goods including petrol, alcohol, and tobacco products. These taxes are often used to discourage consumption of particular products while raising government revenue.

Customs duties are paid when importing certain goods from abroad. These taxes can make imported products more expensive compared to domestic alternatives.

Council tax is paid by residents to local councils to fund local services. Changes in council tax affect household disposable income and therefore consumer spending power.

Business rates are paid by businesses to local councils based on property values. These represent a fixed cost for businesses that must be paid regardless of trading conditions.

How taxation changes affect businesses

Changes in taxation can affect businesses in multiple ways. Understanding these impacts helps businesses plan for policy changes and adjust their strategies accordingly.

Impact on consumer spending

Reductions in income tax, increases in personal tax allowances, or cuts to inheritance tax rates leave consumers with more disposable income. This increased purchasing power typically leads to higher consumer spending, which benefits businesses selling goods and services. Conversely, increases in income tax, National Insurance contributions, or council tax reduce disposable income and can lead to lower consumer demand.

Effects on prices

Increases in VAT or excise duties raise business costs. Most businesses respond by passing these costs onto customers through higher prices. However, this strategy carries risks – higher prices may reduce sales volume, particularly in competitive markets where consumers can switch to cheaper alternatives.

Customs duty increases make imported goods more expensive. This affects both businesses that rely on imported supplies and consumers purchasing imported products.

Business costs, revenue and profits

Tax increases can significantly impact business profitability. VAT increases raise costs across the supply chain. Businesses may attempt to maintain profit margins by raising prices, but this can reduce sales volume if demand is price elastic.

Corporation tax increases directly reduce after-tax profits. Higher business rates represent increased fixed costs that must be paid regardless of business performance. Employers' National Insurance contribution increases raise the cost of employing workers, making labour more expensive.

Tax reductions have the opposite effect, potentially increasing business profitability. Lower corporation tax rates leave businesses with more retained profit for reinvestment or dividend payments.

Business spending and investment

Higher taxes reduce retained profits, affecting a business's ability to meet its financial obligations and invest in growth. Reduced retained profit can limit a business's capacity to pay suppliers, purchase stock, invest in new equipment, or expand facilities.

Impact on shareholding

Changes in capital gains tax and stamp duty affect investor behaviour. An increase in capital gains tax may discourage investors from selling shares or delay sales to avoid higher tax bills. This can reduce market liquidity and affect share prices.

These tax changes can influence how attractive equity investment appears compared to other asset classes.

Importing and exporting considerations

Customs duty increases can create both winners and losers. UK businesses competing against imported products may benefit if higher customs duties make imports more expensive, improving their competitive position.

However, UK businesses that rely on imported raw materials or components face higher input costs when customs duties rise. This reduces their competitiveness and profit margins unless they can pass costs onto customers.

Effects on business operations and employees

Increases in employers' National Insurance contributions make hiring additional workers more expensive. This may deter businesses from recruiting, potentially slowing employment growth or encouraging substitution of labour with capital equipment.

Changes in company car taxation or mileage allowance rates affect how businesses structure employee benefits packages. Higher taxes on these benefits may lead businesses to restructure compensation packages or reduce such benefits.

Sector-specific effects

Certain taxes target specific business activities or sectors. Landfill tax increases encourage businesses to recycle waste rather than disposing of it in landfills. Passenger duty changes affect airlines and tourism businesses by influencing travel costs and demand for holidays.

These targeted taxes can significantly affect business models and operational decisions in affected industries.

Tax avoidance and evasion

When taxes increase, some businesses attempt to minimise their tax liability through avoidance (legal) or evasion (illegal) strategies. Tax avoidance might involve restructuring operations, such as not hiring workers to avoid higher National Insurance payments, or switching from imported to domestic supplies to avoid customs duties.

Government expenditure

The government manages spending across the public sector, providing essential services including education, healthcare, defence, welfare benefits, and transport infrastructure. In 2014, the UK government spent £732 billion across these various services.

The largest category of government spending is social protection (including welfare benefits and pensions) at £222 billion, followed by health at £140 billion and education at £98 billion. Other significant spending areas include defence, transport, and debt interest payments. The debt interest alone represents £53 billion – money that could potentially be redirected to public services if government debt were eliminated.

How government expenditure changes affect businesses

Government spending levels significantly influence business activity across the economy. When government increases spending beyond its tax revenues, total spending in the economy rises. This increased aggregate demand typically benefits many businesses through higher sales and revenue.

However, the relationship is complex. Excessive government spending can create economic problems including inflation and pressure for higher interest rates, which can offset the benefits of increased demand.

Recent UK government spending policy

In recent years, the UK government has attempted to reduce spending in various departments to cut government borrowing. The government has worked to reduce the annual deficit – the gap between government spending and tax revenue. This has proved challenging, and deficit reduction has taken longer than initially planned.

Spending cuts have included freezing most public sector pay since 2010. These measures, combined with other austerity policies, have reduced disposable income for many households. This has affected businesses adversely in some sectors, particularly retail. Some retailers have experienced falling demand, and several have collapsed during this period.

The business cycle

Over time, economies typically grow as measured by Gross Domestic Product (GDP) – the total value of output in the economy. However, this growth is rarely smooth or consistent. Instead, economic growth fluctuates in a pattern known as the business cycle, economic cycle, or trade cycle.

Boom

The boom represents the peak of the business cycle when GDP is growing rapidly and the economy is performing strongly. During boom periods, several characteristics emerge:

• Existing businesses expand their operations and new firms enter markets
• Consumer and business demand rises significantly
• Employment grows as businesses recruit to meet increased demand
• Wages typically rise as competition for workers intensifies
• Business profits generally increase due to higher sales volumes

However, boom periods also bring challenges. Prices often rise sharply due to high demand, potentially creating inflation. Asset prices, particularly property, can increase dramatically. In the UK, house prices rose sharply during the boom periods of the 1990s and 2000s when GDP was growing rapidly.

Downturn

Following a boom, the economy enters a downturn phase. The economy continues growing, but at a declining rate. Key features of a downturn include:

• Demand for goods and services begins to flatten or fall
• Unemployment starts to rise as businesses become more cautious about hiring
• Wage growth slows down as labour market conditions ease
• Many businesses halt expansion plans
• Profits may decline even as revenue continues to grow
• Price inflation slows as demand pressures ease

The downturn phase signals that the economy is losing momentum and may be heading toward recession if conditions continue to deteriorate.

Recession or depression

At the bottom of the business cycle, GDP may become flat or even fall. When GDP declines for two consecutive quarters, economists define this as a recession. A more severe and prolonged decline is called a depression or slump.

Recession periods are associated with economic hardship. Key characteristics include:

• Demand falls significantly, particularly for non-essential goods and services
• Unemployment rises sharply as businesses cut jobs to reduce costs
• Business confidence collapses, affecting investment decisions
• Bankruptcy rates increase as businesses struggle with falling revenue and existing debts
• Prices may remain flat, and some prices may actually fall (deflation)

During recessions, businesses face severe challenges including reduced revenue, difficulty accessing finance, and pressure to cut costs drastically. Consumer spending falls as unemployment rises and job security concerns increase.

Recovery or upswing

When GDP begins rising again following a recession, the economy enters a recovery or upswing phase. During this phase:

• Business and consumer confidence gradually returns
• Economic activity increases across most sectors
• Demand begins rising for goods and services
• Unemployment starts falling as businesses begin hiring again
• Prices begin rising as demand recovers
• Investment increases as businesses become more optimistic about future growth

Impact of the business cycle on businesses

The business cycle's fluctuating pattern significantly affects business performance, though the magnitude of impact varies by sector and business type. Businesses must understand these patterns to plan effectively and manage risks.

During boom periods, most businesses benefit from rising demand and can expand operations. However, they must be careful not to overextend themselves, as boom periods eventually end. Businesses need to manage cash flow carefully and avoid taking on excessive debt that could become problematic when conditions deteriorate.

During downturns and recessions, businesses face falling demand and must focus on cost control and efficiency. Some businesses may need to restructure operations, reduce workforce, or exit unprofitable markets. However, recessions can also create opportunities for well-positioned businesses to gain market share or acquire struggling competitors.

Different industries experience different impacts. Luxury goods and services typically suffer more during downturns as consumers prioritise essential spending. In contrast, discount retailers or budget service providers may actually benefit as consumers trade down to cheaper alternatives.

Businesses selling essential goods and services tend to be more resilient during economic downturns, as demand for necessities remains relatively stable. However, even these businesses may face pressure on profit margins as consumers become more price-sensitive.

Understanding the business cycle helps businesses make informed decisions about timing investments, managing inventory levels, adjusting pricing strategies, and planning workforce requirements.

Exam focus: evaluation skills

When evaluating the impact of taxation or government expenditure changes on businesses, consider:

Remember!