Extract E (lines 18–19) states ‘the 2017 Budget Report stated the intention to reduce the rate of corporation tax further to 17% by 2020.’ Explain how a reduction in corporation tax on firms’ profits might lead to supply-side improvements in the economy. (June 2018)
Corporation tax is a tax on business profits. A reduction in corporation tax will mean that business profits after tax will increase. This can lead to an increase in the budget that firms can use to invest in their factors of production. For example, if firms on average, increase their spending on capital, then firms will be able to increase their productivity, which is output per worker per hour. Overall, firms will be able to produce more when they are at working at their productive capacity, so there would be an increase in LRAS in the UK economy. Another reason why lower corporation tax can lead to supply-side improvements is because more firms will choose to relocate to the UK, as they are incentivised by the ability to retain more profits. This also leads to the productive potential of the economy increasing as there are more firms working to produce goods and services. Overall, this leads to a right shift in LRAS as shown in the diagram below.
LRAS RIGHT SHIFT DIAGRAM
This leads to an outcome where real GDP increases from y1 to y2 and price level decreases from pl1 to pl2.