Question

1. When income tax is lowered to 20% level, how much more growth can be obtained?

2. When dividend tax is 0%, how much more growth can be obtained?
3. Which policy is better for the government? And which policy is better for the company? Why would government employ these 2 policies simultaneously?

Answer 1

1. When tax is lowered by 20% , it increases disposable income of the tax paying segment of population.Since larger portion of income is in the hands of workers, so they would work for higher hours and substitute work for leisure.Further, despite wage increase workers find increase in their real purchasing power.   This boosts consumption and shifts Aggregate demand rightwards and increases output.

Fall in taxes has a multiplier effect on consumption and output. It increases output by a larger proportion than tax cuts.

2. When dividend tax is lowered to 0% , it means tax on equity, mutual funds holdings etc are nil. So companies would most likely declare dividends at this point of time. ( share of profits distributed to shareholders.) Further investors and financial institutions would invest in dividend schemes as it raises their value of savings without effort. Higher savings today means higher consumption in next period , so investment will rise now. This would increase output as well due to increase in investment. Again due to effect of investment multiplier, output will increase by higher proportion than dividend tax cuts.

3. Historically tax cuts on income are considered populist policy measures of the government. Increase in purchasing power makes people happy with the government and most likely they will be voting for the this government. So it is good for government as it may help them win elections.

Further divided tax cuts is good for company as it can now distribute its profits to shareholders without paying any taxes. This makes shareholders happy and will continue to invest. As investments through equity is cheaper ( in terms of financing of projects)as compared to borrowings therefore it is good for company.

Government should employ the two measures simultaneously as the income tax cuts boosts consumption, and dividend tax cuts boosts investment via savings.

If income tax cuts are financed by govt. borrowings ( assuming Govt. expenditure is constant) then it may lead to inflationary tendencies causing interest rates to rise over time. Further it may also crowd out private investments. In order to balance it may simultaneously announce corporate tax cuts or dividend tax cuts so that alternative financing through equity is available for private investors and savings and investments are also increased.