IGCSE Economics Paper-2: Specimen Questions with Answers 62 - 63 of 100

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“In developing countries, in contrast, inflation is not purely a monetary phenomenon. Factors typically related to fiscal imbalances, driving higher money growth and exchange rate depreciation, dominate the inflation process in developing countries.”

Question 62 (1 of 5 Based on Passage)


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What is the effect of tax on budget?


  • If there is a tax cut it can slow down the economic growth in the long-run by increasing budget deficits and vice versa. The government borrows finance by diverting some capital that would have gone to private investment when the economy is operating near potential. Government finances its borrowing either this way or by borrowing from foreign investors.

Government borrowing thus,

  • Either increases the private investment by reducing future productive capacity relating to what it could have been,
  • Or it reduces the future income from that investment.

In both the ways deficits can reduce future well-being of the residents.

The effects of tax policies in the long-run thus depend not only on their incentive effects but also on their budgetary effects. If marginal tax rates are reduced on individual incomes, for example, the long-run effects of taxes can be either positive or negative. It depends on the resulting impacts on saving and investments.

A Tax Incentive Refers

Question 63 (2 of 5 Based on Passage)


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How taxes help the economy eventually?


Impact of Direct Taxation – Income Tax

Income tax is a levied on the income earned by an individual, HUF, company, or an association of persons.

For example: In the United Kingdom, the rate of income tax is 20 % . If the income tax increases what impact does it have?

  • Revenue: The main objective of tax collection is to raise income of the government which can lead to higher amount of expenditure by the government on health care and education, repairing roads, pension, etc.
  • Income: After paying income tax a person will be left with lesser amount of income to spend after the deduction. This will lead to lower amount of spending in the household spending and lower levels of saving.
  • Incentive effect: Higher rate of income tax will reduce the disposable income and can incentive to work. Either worker will choose not to work overtime or leave the labor market altogether. There are two conflicting effects of higher tax rate:
    • Substitution effect: Higher tax will lead to lower wages to workers and work becomes less attractive. The substitution effect of a higher tax rate is - workers will be willing to work less.
    • Income effect: Higher tax leads to lower wage; consequently, a worker may feel the urge to work for longer duration to earn his target level of income. Thus, the income effect means that higher tax may lead to longer work duration for some workers.

Distribution of Income

  • Income tax is a progressive tax. As income level increases, the rate of income tax increases. Income tax plays a role in redistribution of income and offsetting regressive taxes like indirect tax.

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