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What’s it: Net tax equals government tax revenue after deducting transfer payments. It represents the remaining revenue to finance government spending.
Changes in net taxes are closely related to economic growth. For example, tax revenue increases during an expansion as business profits and household income improve. On the other hand, transfer payments declined as the economy became more prosperous. As a result, net taxes tend to decrease.
The opposite effect applies when the economy is in recession, where it will lower net taxes due to decreased tax revenues and increased transfer payments.
Calculate net tax
Calculating net tax is easy because it only requires arithmetic calculations. We get it by deducting tax revenue with transfer payments. Here is the net tax formula:
- Net taxes = Tax revenue – Transfer payments
Tax
The government’s revenue comes mostly from taxes. Other sources include concessions and royalties for resource extraction contracts, asset sales or privatization, dividends from government-owned companies, and foreign aid.
Taxes take many forms, varying between countries. Usually, they include:
- Personal income tax
- Corporate profit tax
- Capital gains tax
- Property tax
- Inheritance tax
- Value-added tax
- Sales tax
- Excise
- Customs
Tax revenue is positively correlated with economic growth. Strong economic growth allows the government to collect more taxes, while weak economic growth reduces tax revenues.
Then, a decrease in tax revenue may be a deliberate policy by the government during weak economic growth or recession. The government cut taxes to stimulate economic growth. Lower taxes increase disposable income. As a result, households have money to spend while businesses have money to invest, stimulating demand for goods and services.
Likewise, the increase in tax revenue can also be intentional by the government. For example, the government raises taxes to weaken aggregate demand, reducing upward pressure on the price level. This step is usually taken when the economy is overheating where inflation is so high and has the potential to disrupt economic stability.
Transfer payment
Transfer payments represent payments to the private sector without exchanging goods and services in return. Examples include unemployment benefits and pension payments. Other examples are social security, student grants, temporary Assistance for needy families (TANF), and social security insurance. Meanwhile, bailouts and subsidies are generally not considered transfer payments.
Transfer payments generally work inversely to economic growth, unlike taxes. As a result, they negatively correlate with economic growth. When economic growth is strong, transfer payments decline because the economy is more prosperous. Conversely, when economic growth is weak, transfer payments tend to increase.
The relationship between net tax and economic growth
During the expansion, the economy grew strongly. As a result, businesses face strong earning prospects. Likewise, households are optimistic about their income and employment. As an impact, the government can collect more taxes.
In addition, during the expansion, the economy prospered. As a consequence, the unemployment rate was low. Thus, transfer payments such as unemployment benefits decreased during this period.
As tax revenues increase, and at the same time, transfer payments decrease, net taxes increase.
On the other hand, during a recession, economic growth falls and is in negative territory. The unemployment rate is rising. In addition, businesses face pressure on their profitability. Meanwhile, households also see their income and employment prospects deteriorate. As a result, tax revenues decrease while transfer payments increase, resulting in a decrease in net taxes.
Net tax, budget balance, and national savings
The budget balance is the difference between government revenues and government expenditures. Or, it equals net tax (NT) minus expenditures after adjusting for transfer payments (G). So, the formula for budget balance is as follows:
- Budget balance = NT – G
Meanwhile, national savings are equal to public-sector savings plus private-sector savings. Public savings are linked to the government budget. Private sector savings are equal to household savings plus business savings.
- National savings = Private savings + Public savings
Assume private savings are constant. Thus, the change in national savings equals the change in public savings.
Public savings arise when the government runs a budget surplus, that is, when net taxes exceed government spending. Thus, national savings increase when the government runs a budget surplus.
The surplus is considered savings because it can be invested to support long-term growth. Economists refer to the surplus as loanable funds from the public sector provided by the domestic economy. And the surplus can be used to build up the capital stock in the economy to increase long-run output.
Conversely, the government runs a budget deficit when net taxes are less than spending. And that means public dissavings. The government must borrow from financial markets or external sectors to cover the deficit. Another impact is a decrease in national savings.
The effects of tax cuts on net tax, national savings, and economic growth
Assume government spending is unchanged and the deficit is running. In the first case, tax cuts increase the deficit and decrease national savings, reducing the loanable funds supply. On the other hand, government debt increases because the government has to borrow more to cover the larger deficit.
In the second case, an increase in taxes increases disposable income in the economy. Households have more money to spend on goods and services because they pay fewer taxes. As a result, aggregate demand increases, driving GDP growth. In other words, short-run output increases.
How much tax cuts impact increasing GDP depends on how much additional disposable income is allocated to consumption instead of savings. When more is allocated to consumption, it will give a higher multiplier effect.
- Tax multiplier = – MPC / MPS
MPC refers to the additional consumption resulting from a one-dollar increase in income. Meanwhile, MPS refers to extra savings when income increases by one dollar. Since income is allocated for only two purposes: consumption and saving, the extra income equals the change in consumption plus the change in saving, or MPC plus MPS equals 1.
Say, MPC is equal to 0.8. So, MPS equals 0.2, and the tax multiplier is -4. Meanwhile, the relationship between the tax multiplier and GDP is formulated as follows (how to get it, see here):
- Change in GDP = Tax multiplier x Change in net tax
Assume net taxes fall by $100. That increases GDP by $400 (-4 x -$100). So from the first and second formulas above, we can see that the bigger the MPC, the bigger the tax multiplier and the bigger the tax cuts affect GDP.
Limitations of tax cuts and potential drawbacks
Do tax cuts always work like the second case above? The answer is no.
As noted in the first case, tax cuts increase the budget deficit and government debt, and national savings also decrease. A decrease in national savings reduces the supply of loanable funds in the economy, raising interest rates.
A higher interest rate increases the cost of borrowing. Thus, businesses have to pay more when applying for a loan to invest. This situation finally reduces their interest in investing. Moreover, the decline in investment hurts the capital stock in the economy. Finally, it lowers productive capacity and long-run output.
Finally, debt securities can explain how tax cuts impact interest rates. Tax cuts increase the budget deficit, which means the government must increase its debt. The increase in debt ultimately reduces the government’s ability to repay it, increasing the default risk. Finally, investors demand higher interest rates to compensate for the higher risk.
Because it is a benchmark, an increase in interest rates on government bonds will impact interest rates in the financial market, including an increase in interest rates on the corporate debt market. Finally, companies have to pay more when issuing debt securities.
