(a) Explain what is meant by fiscal neutrality in relation to a taxation system, and consider whether it is a desirable feature of such a system.
Fiscal neutrality is a concept that describes a state wherein the net effect of taxation is neutral, and does not have any substantial effect on demand. When applied to taxation and fiscal policy, it espouses a balanced budget where total tax revenue equals total public spending, or where any new tax revenue equals any new public spending. A tax can be considered neutral if its payment as a percentage of income is constant as the income rises. This principle also implies that tax regulation should not discriminate between enterprises or individuals of any size.
This policy is regarded as an ideal, as well as a criterion for a good tax system. Fiscal neutrality, on the large part, is believed to result in a more effective allocation of resources. The object of fiscal neutrality however, is not to leave the income distribution the same as if a tax had not been imposed, but to affect economy and income distribution in the same way as if the taxes were a free-market price.
The use of neutrality answers the issue as to why the government should alter market conditions, and under what terms. A system without imposed taxation would result in a purely free-market system, while if the government purely imposes taxation, the result would be socialism. The ideal therefore, is to pursue neutrality.
(b) Analyse how taxation issues may influence an individual’s decision as to whether or not to work overtime.
When changes in the marginal income tax rates are applied, the conditions “at the margin” of the budget constraint can be expected to change and affect an individual’s willingness to work. Tax cuts, for example, may change an individual’s optimal budget segment and induce the individual to take overtime work.
Taxation can discourage overtime work and induce a greater demand for higher compensation in order to overcome the effects of the income tax. For example, a bracket scale in withholding taxes affects willingness to work when earning additional sums of money would result in being put in a higher tax bracket and a smaller net wage after withholding. Heavy taxation can also discourage working overtime when the individual feels that rest and leisure are more important than the compensation incurred from additional hours of work after meeting heavy taxes.
In some cases, however, higher taxes can encourage an individual to work overtime. A person may be more willing to produce so that the person can take home the same amount of money (net earnings) as before taxes have been applied.
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