(a) Explain, with examples, why the impact on expenditure from a reduction in the rate of income tax depends on a good’s income elasticity of demand.                                         [10]

Income tax is the tax on household’s income, and it will affect household’s disposable income, which is the after-tax income. Income elasticity of demand (YED) measures the degree of responsiveness of demand for a good due to a change in income, ceteris paribus. The question on how a fall in income tax rate affects the expenditure on goods and services can explained by examining goods with different YED – luxury, necessity, inferior goods.

When the income tax falls, it will increase the household’s disposable income and hence affect the demand for a good. Whether the demand for a good will rise or fall depends on whether the good is a normal or inferior good. A normal good is a good whose demand rises when income rises (i.e. YED > 0). A normal good is further sub-categorised into 2 types – necessity and luxury goods. A necessity good is a good whose demand rises by a smaller proportion / percentage when income rises, hence has income-inelastic demand (0 < YED < 0). A luxury good is a good whose demand rises by a larger proportion, hence has income-elastic demand. (YED > 1). A inferior good is a good whose demand falls when income rises. (YED < 0).

When income tax falls, the demand for normal goods will rise, resulting in a rise in both equilibrium price and qty, thereby leading to a rise in expenditure.

In the above diagram, when the demand rises, there will a shortage of Q3Q1. When firms do not produce enough to sell,  they can raise prices without losing sales. Hence, this puts an upward pressure on prices. When price rises from P1 to P2, quantity demanded will fall from Q3 to Q2 and quantity supplied will rise from Q1 to Q2 until the new equilibrium is reached at Q2, where the price is P2.

When demand rises for normal goods, whether the expenditure will rise by a larger or smaller extent depends on the YED of normal goods. For example, the demand for necessity good (e.g. food, 3 star hotel, 4 star hotel) will rise by a smaller extent than the demand for luxury good (e.g. branded watches, 5 star hotel), hence the rise in expenditure on necessity good will be lesser than luxury good.

In the above diagram, due to the large rise in demand for luxury good from D1 to D3 as compared to demand for necessity good from D2 to D3, there will a larger rise in expenditure (P3 x Q3) for luxury good compared to rise in expenditure (P2 x Q2) for necessity good.

When income tax falls, the demand for inferior goods (e.g. motels, supermarket house brands) will falls, resulting in a fall in both equilibrium price and qty, thereby leading to a fall in expenditure.

In the above diagram, due to the fall in demand for inferior goods from D1 to D2, there is a fall in expenditure from P1 x Q1 to P2 x Q2.

In conclusion, the fall in income tax will increase the expenditure of normal goods and decrease the expenditure of inferior goods. The expenditure on luxury goods will rise by a larger extent than necessity goods. Hence, the impact on expenditure depends on the YED of the good.

(b) Discuss whether firms can increase the price of all products by the full amount of the goods and services tax increase.                                                                          [15]

Goods and Services Tax (GST) is a tax levied on producers, and will increase their costs of production. Whether firms can increase the prices of all products by the full amount of the GST increase can be discussed with reference to the concepts of price elasticity of demand (PED). PED measures the degree of responsiveness of quantity demanded due to a change in price, ceteris paribus.

An rise in GST will lead to a rise in the costs of production. When this happens, firms will increase price by the amount of the tax at each quantity to maintain profitability. In other words, they will decrease quantity at each price which will lead to a decrease in supply. Usually for GST, it is set at a certain percentage of the price, hence it is also known an ad-valorem tax.

In the above diagram, an increase in GST leads to a pivotal upward shift in the supply curve (S) from S0 to S1 as the amount of the tax increases when the quantity increases, and this is because a higher quantity corresponds to a higher price on the supply curve.

When GST is increased, firms cannot increase the price by the full amount of tax because the tax burden is typically co-shared between the firms and consumers.

In the above diagram, the rise in GST is shown by an upward shift from So to S1 (pink). This fall in the supply results in a rise in price from Po to P1, and the fall in quantity from Qo to Q1. At the new equilibrium quantity Q1, the GST collected per unit of good is t, of which the rise in the price is a fraction of the tax which is from Po to P1. The firm is not able to pass through the full extent of the tax to the consumer because this will create a surplus which will drive the price down. In this example, the GST revenue collected will be the shaded area, of which the firm will pass through part of the GST to the consumer from (P1 – Po) / t.

The extent to which the firm can pass through the tax in the form of rise in the price depends on PED. If the PED is inelastic, the firm will be able to pass through a large proportion of the tax in the form of price increase from Po to P1.

In the above diagram, the demand is less price elastic than the supply and hence the demand curve (D0) is relatively steeper. The proportion of the tax (t) paid by consumers, which is (P1 − P0)/t is greater than the proportion paid by firms, which is [P0 −(P1 −t)]/t. Hence the firm is able to pass through a large amount of tax to consumers if PED < 1.

If the demand for a good is price elastic (PED > 1), the firm will be able to pass through a small proportion of the tax in the form of price increase from Po to P1.

In the above diagram, the demand is price elastic and hence the demand curve (D0) is relatively gentler. The proportion of the tax (t) paid by consumers, which is (P1 − P0)/t is smaller than the proportion paid by firms, which is [P0 −(P1 −t)]/t. Hence the firm is able to pass through a small amount of tax to consumers if PED > 1.

Firms will only be able to pass through all the tax to consumer in the form of the increase in the price if the demand is perfectly price inelastic.

In the diagram above, due to PED = 0, the firm will be able to pass through the full amount of the GST increase to consumer in the form of price increase from Po to P1.

In general, when consumers are more responsive to a change in the price (i.e. PED > 1), firms will not be able to pass on a larger proportion of the tax to consumers in the form of a large increase in the price without causing a large decrease in the quantity demanded. Conversely, when consumers are less responsive to a change in the price (i.e. PED < 1), firms will be able to pass on a larger proportion of the tax to consumers in the form of a large increase in the price without causing a large decrease in the quantity demanded. Unless in the special scenario of PED = 0 which is unlikely to occur in reality, firms will then be able to pass through the full amount of the tax to consumers.

In the final evaluation, the above analysis assumes ceteris paribus, which means all things being equal. Often times the GST increase is also accompanied with other factors affecting the demand and supply, which could make it harder examine whether firms are passing through part or fully the extent of the rise in GST. For example, the GST increase in Singapore from 2022 to 2024 of 7% to 9%, should theoretically increase prices by 2% by the maximum. However, the prices of goods and services in Singapore inflated by more than that, which suggested that there could be other increases in costs, or factors that increases demand such as income and changes and tastes and preferences. Hence the above analysis is at best a theoretical analysis which is unlikely to be observed in reality.