Economics Case Study


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Case Study
When taxes induce people to change their behaviour—such as inducing Jane to buy less
pizza—the taxes cause deadweight losses and make the allocation of resources less
efficient. As we have already seen, much government revenue comes from the
individual income tax in many countries. In a case study in Chapter 8, we discussed
how this tax discourages people from working as hard as they otherwise might. Another
inefficiency caused by this tax is that it discourages people from saving.
Consider a person 25 years’ old who is considering saving $1,000. If he puts this money
in a savings account that earns 8 percent and leaves it there, he would have $21,720
when he retires at age 65. Yet if the government taxes one-fourth of his interest income
each year, the effective interest rate is only 6 percent. After 40 years of earning 6
percent, the $1,000 grows to only $10,290, less than half of what it would have been
without taxation. Thus, because interest income is taxed, saving is much less attractive.
Some economists advocate eliminating the current tax system’s disincentive toward
saving by changing the basis of taxation. Rather than taxing the amount of income that
people earn, the government could tax the amount that people spend.
Under this proposal, all income that is saved would not be taxed until the saving is later
spent. This alternative system, called a consumption tax, would not distort people’s
saving decisions.
Various provisions of the current tax code already make the tax system a bit like a
consumption tax. Taxpayers can put a limited amount of their saving into special
accounts—such as Individual Retirement Accounts and 401(k) plans—that escape
until the money is withdrawn at retirement. For people who do most of their saving
through these retirement accounts, their tax bill is, in effect, based on their consumption
rather than their income.
European countries tend to rely more on consumption taxes than does the United States.
Most of them raise a significant amount of government revenue through a value-added
tax, or a VAT. A VAT is like the retail sales tax that many U.S. states use, but rather
than collecting all of the tax at the retail level when the consumer buys the final good,
the government collects the tax in stages as the good is being produced (that is, as value
is added by firms along the chain of production). Various U.S. policymakers have
proposed that the tax code move further in direction of taxing consumption rather than
income. In 2005, economist Alan Greenspan, then Chairman of the Federal Reserve,
offered this advice to a presidential commission on tax reform: “As you know, many
economists believe that a consumption tax would be best from the perspective of
promoting economic growth—particularly if one were designing a tax system from
scratch—because a consumption tax is likely to encourage saving and capital
formation. However, getting from the current tax system to a consumption tax raises a
challenging set of transition issues.”
1: What should be taxed – Personal Income or Personal Consumption and
why? Provide your opinion based on the case.
(200 words) [1.5
2: How may it affect Saudi Economy if an income tax is imposed in
(200 words) [1.5
Q2: Saudi Arabia’s Ministry of Human Resources recently announced an increase to
the monthly minimum wage from 3000 SAR to 4000 SAR for full-time Saudi workers
in April 2021, and introduced a Labor Reform Initiative (LRI) scheduled to take effect
on 14th March 2021.
a. Discuss the implications of the above topic.
b. Will this impact unemployment in the country? How?

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Explanation & Answer:
200 words




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