Explain what might happen to national income if the Singapore government were to reduce personal and corporate income tax rate? (10m)

A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross national product (GNP). All are specially concerned with counting the total amount of goods and services produced within some “boundary”. The boundary is usually defined by geography or citizenship. To understand the impact of a reduction of personal and corporate tax on the total amount of goods and services produced, we will need to understand the link between them both using the circular flow of income. In this essay, we will explain the circular flow of income as well as explain how a reduction in taxes will likely cause an increase in national income by a multiplied amount via the multiplier effect.

The circular flow of income shows connections between different sectors. It revolves around flows of goods and services and factors of production between firms and households.

Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

  • Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
  • Paid to the government in taxation (T) e.g. income tax and national insurance
  • Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output).

circular flow of income

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

  1. Capital spending by firms, i.e. investment expenditure (I)
  2. The government, i.e. government expenditure (G)
  3. Overseas consumers buying goods and service

An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.

The amount of income generated in a given economy within a period of time (national income) can be viewed from three perspectives. These are:

  • Income,
  • Product, and
  • Expenditure.

The above assertion implies that we can view national income as either the total sum of all income received within a particular period (income); the total good and services produced within a particular period (product) or total expenditure on goods and services within a given period (expenditure).  Whichever approach is used, the value we get is the same.

A reduction in taxes whether corporate or income will eventually increase national income. This is because the reduction in tax is a reduction of leakages in the economy. The effect is a direct increase in disposable income among individuals and hence consumption within the economy. Likewise a reduction in corporate tax will likely allow firms to increase their investment. Both an increase in consumption and investment will lead to an increase in the national income.

For example, all resident individual taxpayers were given a one-off income tax rebate of 20%, up to a cap of $2,000, for the tax  payable for  Year of Assessment (YA) 2009. Corporate income tax rate was reduced from 18% to 17% to help maintain Singapore’s competitiveness in 2010.  These are some of the measures to combat a slow down in the Singapore economy due to the global financial crisis. The effect is to increase the consumption and investment respectively and hence national income.

Every time there is an injection or reduction of leakages into the circular flow there is likely to be a multiplier effect which will lead to a multiplied increase in national income. This is because an injection of extra income leads to more spending, which creates more income, and so on. The multiplier effect refers to the increase in final income arising from any new injection of spending.

The size of the multiplier depends upon household’s marginal decisions to spend, called the marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps). It is important to remember that when income is spent, this spending becomes someone else’s income, and so on. Marginal propensities show the proportion of extra income allocated to particular activities, such as investment spending by Singapore’s firms, saving by households, and spending on imports from abroad. For example, if 80% of all new income in a given period of time is spent on Singapore products, the marginal propensity to consume would be 80/100, which is 0.8.

The following general formula to calculate the multiplier uses marginal propensities, as follows:

1/1-mpc

Hence, if consumers spend 0.8 and save 0.2 of every $1 of extra income, the multiplier will be:

                1/1-0.8
                = 1/0.2
                = 5

Hence, the multiplier is 5, which means that every $1 of new income generates $5 of extra income.

To conclude, a reduction in both corporate and income tax will increase the national income by a multiplied amount, as explained above via the circular flow of income and the multiplier effect.