Question

The Kingdom of Bahrain enacted a 5% value-added tax (consumption tax) on certain items. Consumption, or current expenditure, is an alternative to income as a tax base. However, the notion of directly taxing consumption in a manner similar to the way income is taxed was recommended for several considerations. The notion is also reflected in economic analysis inasmuch as taxes are evaluated in terms of their effects on the economy at large.

Read carefully the above statement and answer the following questions. Be sure to provide details explanations about the questions below.

Explain why economists argue that an income tax penalizes savers but a consumption tax would not. In what sense can consumption be regarded as a better index of the ability to pay taxes than income?

Explain how budget deficits contribute to increased market rates of interest and reduced private investment. In case the government borrows money to pay for public services, explain how repayment of government debt constitutes a redistribution of income among citizens?
In 2018, the national debt in the Kingdom of Bahrain reached to 95% of the country gross domestic product. As an alternate government financing, how do you explain the causes and consequences of the national debt on the economy in Bahrain. Do you agree/disagree with the government to borrow money to pay for public services?

Suppose you are appointed a minister of finance in Bahrain and you want to introduce some recommendations to support government public good programs. What do you propose that the government should do to increase revenues? Do you think imposing tax on corporation is good or bad? Why or why not?

Answer 1

An income tax penalizes savers but a consumption tax does not because, income which is earned is taxed and that leaves less income for the common man to save, whereas when a consumption tax is imposed, spending is penalised, which leads to people saving more and spending less.

Consumption can be regarded as a better index of the ability to pay taxes because people spend when they have enough disposable income. Enough disposable income implies that they have enough income and thus are able to spend on goods and services. Whereas one taxes people based on their income, they have to pay a certain percentage of income which is fixed, thus even if the citizens do not earn enough they have to spend certain amount on taxes, whereas when they spend on consumption they are able to pay for the goods and services and the quantum is not fixed. Thus in income taxes, even if they are not able to pay, they have to pay a certain percentage.

Budget deficits imply that the government has lower revenue and higher expenditure. This extra expenditure is either funded through increased taxes or borrowings. Thus as demand for credit increases because government and private sector is also vying for credit, the market rates increase because of higher demand and this leads to reduced private investments as the cost of credit increases, and firms try to avoid paying a higher interest cost.

If the government borrows money to pay for public services, repayment of government debt leads to redistribution of income among citizens because governments borrow by selling bonds in the market, when the debt is repaid the citizens are paid for the money which they lent by repaying the principal and the interest which redistributes income.

Causes of higher national debt are higher borrowings because of lower revenues as oil prices decline and when the government has not diversified its revenue stream, lower output, while consequences are larger reliance on reserves in order to seek foreign credit, or convert into cash to increase national currency, which leads to higher money supply and less reserves. The bond yields which the government issues to the public reduce for a long term horizon, which leads to less number of capital inflows as people are unwilling to lend to the government because of lower yields. Lower capital investments and output as most of the government income goes on repaying debt.

The government should borrow money only when it is extremely necessary to borrow and when the money is being borrowed to increase capital expenditure, not when the money is borrowed to repay interest payments which increases the risk of future debt payments. Thus I agree when the government borrows money for public services such as housing and infrastructure.

In order to increase revenues the government should tax products which have inelastic demand, wherein even if the price increases, the demand doesn't reduce, such as tax on petroleum products, alcoholic and tobacco products, higher tariffs so that local manufacturing increases.

Imposing tax on corporates is bad for the economy because the government is already in debt, it can't reduce the profitability of the corporates by taxing them as investment will reduce in the economy, this might lead to lower job creation and capacity constraints wherein output reduces and the economy is not able to produce enough goods and services.