National Income and Government Taxes

Subject: Economics
Topic: 5
Cambridge Code: 0455 / 2281

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National Income Measures

Gross Domestic Product (GDP)

GDP - Total value of goods and services produced within country

$\text{GDP} = \text{C} + \text{I} + \text{G} + (\text{X} - \text{M})$

Where:

• C = Consumer spending
• I = Investment
• G = Government spending
• X = Exports
• M = Imports

Characteristics:

• Includes all production within border
• Regardless of who owns factors
• Market prices
• Annual measurement

Gross National Income (GNI)

GNI - Total value earned by residents

$\text{GNI} = \text{GDP} + \text{Income from abroad} - \text{Income paid abroad}$

Difference from GDP:

• GDP: Production location (physical border)
• GNI: Who earns income (nationality)

Example:

• Japanese factory in UK: Counts in UK GDP, but not GNI
• UK factory in Japan: Counts in UK GNI, but not GDP

Real vs Nominal

Nominal GDP:

• Current prices
• Affected by inflation
• Can increase without real growth

Real GDP:

• Constant/base year prices
• Inflation removed
• Shows true economic growth

$\text{Real GDP} = \text{Nominal GDP} × \frac{\text{Base Year Price Level}}{\text{Current Year Price Level}}$

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Aggregate Demand (AD)

Aggregate Demand - Total spending on goods and services

$\text{AD} = \text{C} + \text{I} + \text{G} + (\text{X} - \text{M})$

Components

Consumer spending (C):

• Largest component (~60%)
• Affected by income, confidence, interest rates

Investment (I):

• Business capital spending
• Affected by profit expectations, interest rates

Government spending (G):

• Government purchases
• Transfer payments not included
• Affected by policy

Net exports (X - M):

• Exports minus imports
• Affected by exchange rates, world income

AD Curve

Downward sloping (real AD axis):

• Price level ↑ → Real AD ↓ (wealth effect, interest effect)
• Price level ↓ → Real AD ↑

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Taxation

Tax - Compulsory payment to government

Tax Types

Direct taxes (income-based):

• Income tax
• Corporate tax
• Inheritance tax

Indirect taxes (expenditure-based):

• Sales tax/VAT
• Excise tax on specific goods
• Tariffs on imports

Progressive vs Flat

Progressive tax:

• Tax rate increases with income
• % of income increases as income ↑
• Example: Income tax (lower rate at lower income)

Regressive tax:

• Tax rate decreases with income
• % of income decreases as income ↑
• Example: VAT (same % for all, but lower earners pay larger % of income)

Proportional tax:

• Tax rate stays same
• Fixed % of income

Tax Functions

Revenue raising: Finance government spending Redistribution: Progressive tax reduces inequality Protection: Tariffs protect domestic industry Pollution control: Carbon tax discourages pollution

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Government Spending

Public spending - Government expenditure

Types

Current spending:

• Wages for public employees
• Running NHS, schools
• Interest on debt

Capital spending (Investment):

• Infrastructure (roads, bridges)
• Schools, hospitals
• Transport

Multiplier Effect

Multiplier - Initial spending creates additional income

Example: Government builds school (£1m)

1. Construction workers earn £1m (income)
2. They spend, say, 80% = £0.8m (leakage 20%)
3. Suppliers earn £0.8m, spend 80% = £0.64m
4. Further rounds continue

Total income generated: $\text{Total effect} = \text{Initial spending} × \frac{1}{1 - \text{MPC}}$

Where MPC = Marginal Propensity to Consume

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Fiscal Policy

Fiscal policy - Using taxation and government spending

Expansionary Fiscal Policy

Objective: Increase AD when economy weak

Methods:

• Decrease taxes (consumers spend more)
• Increase government spending
• Or combination

Effect:

• AD shifts right
• Output increases
• Employment increases
• May cause inflation if overused

Contractionary Fiscal Policy

Objective: Decrease AD when economy overheating

Methods:

• Increase taxes
• Decrease government spending

Effect:

• AD shifts left
• Output decreases
• Inflation controlled
• May increase unemployment

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Budget Position

Budget balance - Tax revenue minus government spending

Budget surplus:

• Revenue > Spending
• Government saves
• Contractionary

Budget deficit:

• Spending > Revenue
• Government borrows
• Expansionary

National Debt

National debt - Accumulated government borrowing

Consequence of persistent deficits:

• Interest payments increase
• Future flexibility limited
• Risk of loss of confidence (if very high)

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Macroeconomic Objectives

Governments aim for:

1. Economic growth: Increase real GDP
2. Low unemployment: Full employment
3. Price stability: Low inflation
4. Balance of payments: Sustainable trade
5. Equity/fairness: Reduce inequality

Trade-offs

Inflation vs Unemployment (Phillips Curve):

• Lower unemployment → Higher inflation (in short run)
• Higher unemployment → Lower inflation

Growth vs Inflation:

• Faster growth → Inflation risk
• Controlling inflation → Growth slows

Difficult to achieve all simultaneously

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Key Points

1. GDP: Production within territory
2. GNI: Income earned by residents
3. Real GDP: Controls for inflation
4. AD: C + I + G + (X - M)
5. Direct taxes on income, indirect on spending
6. Progressive tax reduces inequality
7. Fiscal policy: G spending and taxation
8. Multiplier: Spending creates further income
9. Trade-offs between objectives
10. Government uses fiscal policy to manage economy

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Practice Questions

1. Calculate GDP and GNI
2. Compare nominal and real GDP
3. Categorize taxes
4. Analyze tax progressivity
5. Calculate multiplier effects
6. Design fiscal policy
7. Analyze budget position
8. Compare policy options

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Revision Tips

• Know GDP calculation
• Understand national accounts
• Know tax types clearly
• Understand fiscal policy
• Know multiplier concept
• Understand macroeconomic trade-offs
• Practice calculations
• Know policy tools