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NSS Exploring Economics 5

Chapter 6

Fiscal policy and the budget

Questions
P.162
Think it over
1.
What is a budget? Do you prepare a budget to plan your expenditure and income each month?
2.
Can you cite some sources of government revenue and types of government expenditure
in Hong Kong?
3.
How do government revenue and government expenditure affect the Hong Kong economy?

P.163
Fig 6.2
According to the equity principle, who should pay more tax?

P.165
Discuss 6.1
By the benefit principle, those who benefit more from public services should pay more taxes.
By the ability-to-pay principle, those who have a higher ability to pay (measured by income
or wealth) should pay more taxes. Which principle is more preferable?

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Questions and Answers to Exercises (Chapter 6)

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P.169
Test yourself
6.1
a. When a taxpayers income (taxable income or total income) increases, how do the tax
rate and tax payment of taxes with different progressivities change? Put your answer in
the table below.
When taxable income increases
Average tax rate

Total tax payment


(= Average tax rate Income)

Progressive tax
Proportional tax
Regressive tax
Table 6.4 How do tax rates and tax payments change with income?
b.

Based on the answer in (a), is a tax where the tax payment increases with taxpayers
income necessarily a progressive tax?

6.2
In the diagrams below, identify which taxes are progressive, proportional and regressive.
Then fill in the table below.

Fig. 6.8

Fig. 6.9

Progressive tax
Proportional tax
Regressive tax
Table 6.5 Identification of progressive, proportional and regressive taxes

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P.172
Test yourself
6.3 Suppose a 5% goods and services tax is imposed. Mr Chan, with an annual income of $1
million, spends 20% of his income on consumption each year. Mr Lee, with an annual
income of $100,000, spends 60% of his income on consumption each year. Calculate the
proportions of their income paid as tax by filling in the table below.
Mr Chan

Mr Lee

Annual income
Annual consumption expenditure
Tax payment
Proportion of income paid as tax
Table 6.6 Calculation of tax rates for Mr Chan and Mr Lee
P.173
Discuss
6.2
How will an increase in the sales tax on luxuries affect income distribution?
6.3
What are the effects of the following tax rise/cut on the levels of price and output? (Hint: you
may answer with the help of AS-AD diagrams.)
a. The government lowers the salaries tax rate.
b. The government imposes goods and services tax on sellers.
P.177
Discuss
6.4
With the aid of AS-AD diagrams, explain how the government may use direct taxes or
indirect taxes to solve the problem of deflation caused by (a) a continuous decrease in AD
and (b) a continuous increase in SRAS, respectively.

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P.178
Test yourself
6.4
How can the government relieve the following problems using direct taxes and indirect
taxes? Choose the correct answers in the table.
Problems

Possible solutions
Direct taxes

Indirect taxes

a. Income inequality

Raising / Lowering the


progressivity of direct taxes

Raising / Lowering the


indirect taxes on luxuries

b. Unemployment

Raising / Lowering
direct taxes

Raising / Lowering
indirect taxes

c. Deflation

Raising / Lowering
direct taxes

Raising / Lowering
indirect taxes

Table 6.7 Adjusting direct taxes and indirect taxes to relieve economic problems

6.5
Use an AS-AD diagram to explain why raising direct taxes can reduce both the price level
and the output level.
6.6
Use an AS-AD diagram to explain why raising indirect taxes can reduce the output level and
increase the price level.
P.185
Discuss
6.5
a. According to the above table, what are the highest marginal tax rates for each kind of the
above taxes?
b. Do you prefer living in Hong Kong or France? Why?
P.188
Discuss
6.6
Do you know the effects of the following government policies on the levels of price and
output? (Hint: you may answer with the help of AS-AD diagrams.)

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a. The government reduces the civil service establishment.


b. The government raises the old age allowance.
6.7 How will an increase in unemployment benefits affect income distribution?
P.192
Test yourself
6.7
Explain how the government can combat deflation caused by a continuous decrease in
aggregate demand by adjusting government expenditure.
P. 205-207
Exercises
Multiple Choice Questions
1.
Which of the following is NOT a macroeconomic goal of a government?
A. To achieve full employment
B. To maximise profit
C. To maintain price stability
D. To keep domestic currency stable
2.
In Hong Kong, income taxes are either proportional or progressive. This practice agrees
with the
principle of taxation.
A. equity
B. certainty
C. convenience
D. economy

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3*.
The following diagram shows the tax structure of Tax X:

Tax X is
within the income range 0Y1,
within the income range Y2Y3.
A. progressive, progressive, proportional
B. proportional, proportional, regressive
C. progressive, regressive, proportional
D. progressive, regressive, regressive

within the income range Y1Y2 and

4*.
Which of the following is NOT a difference between direct taxes and indirect taxes?
A. The tax burden of direct taxes cannot be shifted but that of indirect taxes can.
B. Direct tax is generally levied on income and wealth while indirect tax is generally levied
on goods and services.
C. Direct taxes are progressive while indirect taxes are regressive.
D None of the above.
5.
If the government raises the tax rate of a direct tax,
A. both the real national income and the price level would fall in the short run.
B. the real national income would fall but the price level would rise in the short run.
C. both the real national income and the price level would rise in the short run.
D. the real national income would rise but the price level would fall in the short run.

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6*.
Taxable income ($)
10,000
20,000
30,000

Tax payment ($)


Policy A

Policy B

1,000
2,000
3,000

1,000
2,500
4,500

Which of the following is likely to happen if the government changes the tax system from
Policy A to Policy B?
A. The economy would have a less even distribution of income.
B. People have less incentive to work.
C. The tax revenue would increase.
D. The economic growth rate would rise.
7.
Which of the following is an example of indirect taxes levied in Hong Kong?
A. Property tax
B. Fines, forfeitures and penalties
C. Land premium
D. Stamp duty
8*.
If a government cuts its government revenue and government expenditure by the same
amount,
A. the real national income increases in the short run.
B. the real national income remains unchanged in the short run.
C. the real national income decreases in the short run.
D. the effect on real national income is uncertain in the short run.
9*.
The size of the public sector as measured by the ratio of public expenditure to GDP decreases
when
A. the percentage increase in public expenditure is larger than that of GDP.
B. the growth rate of public expenditure is smaller than that of GDP.
C. there is deflation.

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D. the percentage decrease in public expenditure is smaller than that of GDP.

10*.
When Hong Kong suffers a recession, if nominal GDP decreases,
A. revenues from direct taxes and indirect taxes drop by the same percentage.
B. transfer payments would increase.
C. the government would have a deficit in its budget.
D. the size of the public sector would drop.
Short Questions.
1.
Explain the ability to pay principle and the economy principle of taxation suggested by Adam
Smith. Discuss if the goods and services tax proposed in Hong Kong agrees with these two
principles.
(10 marks)
2.
A tax is progressive if its tax payment increases with a taxpayers income. Do you agree?
Explain.
(6 marks)
3**.
a. What are the shortcomings of the following sources of revenue for the government? Fill in
the following table.
(12 marks)
Possible sources of government
revenue

Shortcomings

i. Fees from public services


ii. Land sales
iii. Using past fiscal surplus
iv. Borrowing
v. Fines
vi. Aid or contributions
b. Based on your answers in (a), explain why most governments rely on taxation as the major
source of government revenue.
(5 marks)

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Questions and Answers to Exercises (Chapter 6)

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4. Explain why a balanced budget can bring an expansionary effect to an economy. (8 marks)

Structured Questions.
1.
a. The Hong Kong Government has three main sources of government revenue. Give ONE
example for each source.
(3 marks)
b*. Explain how each of the following events affects the percentage share of direct tax
revenue in total government revenue.
i. During a recovery, both the real GDP and the general price level increase.
(8 marks)
ii. The Hong Kong Government levies a capital gains tax on investors who gain in the
stock market in Hong Kong.
(5 marks)
c*. The environmental levy scheme came into effect in July 2009 in Hong Kong. Retailers
covered by the Scheme are obliged to charge their customers 50 cents for each plastic
shopping bag as an environmental levy.
i. Is this a direct tax or an indirect tax?
(2 marks)
ii. Is this a progressive tax or a regressive tax?
(4 marks)
iii. How does its imposition affect income distribution in Hong Kong? Why? (3 marks)
2.
Suppose the Hong Kong Government plans to increase the personal allowance for the salaries
tax. Discuss its effects on
a. the tax base;
(3 marks)
b. the income distribution;
(7 marks)
c. the output level and the price level with the help of an AS-AD diagram. (For simplicity, the
short run aggregate supply will not be considered.)
(10 marks)
pp.207-208
Activities
1.
Conduct research on the following: How much in taxes did Hong Kongs top 10 salaries
taxpayers and top 10 profits taxpayers pay respectively last year? How large is their tax
payment as a percentage of the total amounts of salaries and profits tax payments?
(Reference: http://www.hkcd.com.hk/content/2010-05/04/content_2518955.htm
http://hkcd.sznews.com/content/2010-05/06/content_2519469.htm)

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2.
Discuss in class the following: What are the pros and cons of imposing direct taxes relative to
indirect taxes? Should the Hong Kong Government increase the proportion of direct tax to
indirect tax? Why?
3.
Study the Brief of Other Options for Broadening the Tax Base and present its major ideas in
class. After the presentation, discuss the feasibility of the proposals suggested in the report.
(Reference: http://www.taxreform.gov.hk/eng/pdf/Other_options.pdf)
4.
Study the current Budget. If you were the Financial Secretary, how would you amend the
Budget? Why?
5.
Debate the following topic: Hong Kong should introduce a goods and services tax.
6.
Debate the following topic: The Hong Kong Government should follow the big market,
small government principle.

Answers
P.162
Think it over
1. A budget is a financial statement of the estimated revenue and expenditure of the
government in a fiscal year.
Your budget: Free answer.
2.

Sources of government revenue To be discussed in this chapter. Teachers may refer to


pp.182-184 for reference.
Types of government expenditure To be discussed in this chapter. Teachers may refer
to p.193 for reference.

3.

Effects of government revenue and government expenditure To be discussed in this


chapter.
Teachers may refer to pp.173-178 for the effects of government revenue, pp.189-192 for

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the effects of government expenditure, and pp.194-198 for the effects of budgets.
P.163
Fig 6.2
The rich man should pay more tax than the poor woman.
P.165
Discuss 6.1
Which principle is more preferable is a normative statement which involves a value
judgement. Since different people have different value judgements, there is no common
consensus among different people as to which principle is more preferable.

P.169
Test yourself
6.1
a.
When taxable income increases
Average tax rate

b.

Total tax payment


(= Average tax rate Income)

Progressive tax

Increases

Increases
(= Average tax rate Income
)

Proportional tax

Remains unchanged

Increases
(= Constant average tax rate
Income )

Regressive tax

Decreases

Uncertain.
If the percentage decrease in the
average tax rate is smaller than
(the same as or larger than) the
percentage increase in income,
the tax payment increases
(remains unchanged or
decreases).

No, it can be a progressive tax, proportional tax or regressive tax.

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6.2
Fig. 6.8

Fig. 6.9

Progressive tax

Tax A, Tax B and Tax C as


their tax rates rise with
income. Their curves are
upward sloping.

Tax F as the tax payment


increases with income at
an increasing rate. The curve
becomes steeper and steeper
when income increases.

Proportional tax

Tax D as its tax rate remains


unchanged when income
increases. Its curve
is horizontal.

Tax G as the tax payment


increases with income at the
same rate. Its curve has a
constant slope.

Tax E as its tax rate


decreases with income. Its
curve is downward
sloping.

Tax H, Tax I and Tax J as


their average tax rates
decrease with income. The
slopes of their curves are
positive but decreasing,
zero and negative,
respectively.

Regressive tax

P.172
Test yourself
6.3
Mr Chan

Mr Lee

Annual income

$1,000,000

$100,000

Annual consumption
expenditure

$200,000
(= $1,000,000 20%)

$60,000
(= $100,000 60%)

Tax payment

$10,000
(= $200,000 5%)

$3,000
(= $60,000 5%)

Proportion of income
paid as tax

1%
(= $10,000 $1,000,000)

3%
(= $3,000 $100,000)

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P.173
Discuss
6.2
As discussed in Learning Tips 6.1, a sales tax on luxuries is progressive in nature. (Assume
that the portion of income spent on consuming luxuries for both the higher and lower income
group remains unchanged after the increase in the tax rate.) An increase in the sales tax on
luxuries raises the tax burden on the rich by a larger percentage than the tax burden on the
poor. Hence, it reduces the income gap or creates a more even (equitable) income
distribution.
6.3
a. When the government lowers the salaries tax rate, peoples disposable income increases.
Hence, private consumption expenditure increases and the aggregate demand curve
shifts rightwards (from AD1 to AD2). Both the real national income (from Y1 to YS2) and
the price level (from P1 to PS2) rise in the short run.
The long run effect depends on whether the short run equilibrium determined by AD and
SRAS lies on the left hand side, the right hand side or exactly on the LRAS curve. The
long run equilibrium is determined by the AD and LRAS and is achieved through the
shifting of SRAS.

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b.

When the government imposes a goods and services tax on sellers, their production costs
rise. The short-run aggregate supply shifts upward (from SRAS1 to SRAS2). Real
national income decreases (from Y1 to YS2) while the price level increases (from P1 to
PS2) in the short run.
The long run effect depends on whether the short run equilibrium determined by AD and
SRAS lies on the left hand side, the right hand side or exactly on the LRAS curve. The
long run equilibrium is determined by the AD and LRAS and is achieved through the
shifting of SRAS.

p.177
Discuss
6.4
a. Deflation caused by a continuous decrease in AD:
Suppose an economy faces a problem of deflation caused by a continuous decrease in
AD from AD0 to AD1. The government can solve the problem by reducing direct taxes
which will increase peoples disposable income and consumption expenditure.
The AD curve shifts upwards and is restored to its original position (AD2 = AD0), the
deflationary pressure is relieved and the price level is stabilised.

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b. Deflation caused by a continuous increase in SRAS:


On the other hand, suppose an economy faces a problem of deflation caused by a
continuous increase in SRAS from SRAS0 to SRAS1. The government can solve the
problem by raising indirect taxes on sellers which will increase their production costs.
The SRAS curve shifts upwards and is restored to its original position (SRAS2 = SRAS0),
deflationary pressure is relieved and the price level is stabilised.

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P.178
Test yourself
6.4
Problems

Possible solutions
Direct taxes

Indirect taxes

a. Income inequality

Raising / Lowering the


progressivity of direct taxes

Raising / Lowering the


indirect taxes on luxuries

b. Unemployment

Raising / Lowering
direct taxes

Raising / Lowering
indirect taxes

c. Deflation

Raising / Lowering
direct taxes

Raising / Lowering
indirect taxes

P.178
Test yourself
6.5 Suppose the original economic situation is represented by Point A where the aggregate
demand curve and the short run aggregate supply curve intersect. When the government
raises direct taxes (e.g., salaries tax), the disposable income of households decreases and
this will lead to a decrease in private consumption expenditure. The aggregate demand
curve shifts leftwards from AD1 to AD2 along the short run aggregate supply curve. The
new economic situation is represented by Point B where both the price level (from P1 to
PS2) and output level decrease (from Y1 to YS2).

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6.6 Suppose the original economic situation is represented by Point A where the aggregate
demand curve and the short run aggregate supply curve intersect. When the government
raises indirect taxes (e.g., indirect taxes on producer goods), the production costs of
sellers increase. This will shift the short run aggregate supply curve upwards from
SRAS1 to SRAS2 along the aggregate demand curve. The new economic situation is
represented by Point B where the price level increases (from P1 to PS2) and output level
decreases (from Y1 to YS2).

p.185
Discuss
6.5
a.
Kind of taxes

b.

Highest marginal tax


rate

Location

Corporate income

34.4%

France

Personal income

53.5%

Belgium

Wealth

1.8%

France

Employer social
security

49%

The mainland of China

Employee social
security

23%

The mainland of China

Sales

21%

Belgium

Free answer. Though the marginal tax rates listed are higher in France than in Hong

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Kong, social welfare is generally better in France than in Hong Kong. Moreover,
different people may have different criteria in choosing a better place to live. Hence, this
question does not have a standard answer.
p.188
Discuss
6.6
a. When the government reduces civil service establishment, government consumption
expenditure drops. Hence, aggregate demand decreases. Both the output level and the
price level drop in the short run (from Y1 to YS2 and P1 to PS2).
The long run effect depends on whether the short run equilibrium determined by AD and
SRAS lies on the left hand side, the right hand side or exactly on the LRAS curve. The
long run equilibrium is determined by the AD and LRAS and is achieved through the
shifting of the SRAS.

b.

When the government raises the old age allowance, recipients disposable income
increases and so does their private consumption expenditure. Hence, aggregate demand
increases. Both the output level and the price level rise in the short run (from Y1 to YS2
and P1 to PS2).
The long run effect depends on whether the short run equilibrium determined by AD and
SRAS lies on the left hand side, the right hand side or exactly on the LRAS curve. The
long run equilibrium is determined by the AD and LRAS and is achieved through the
shifting of the SRAS.

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p.188
Discuss
6.7
An increase in unemployment benefits raises the disposable income of the poor and helps
narrow the income gap.
P.192
Test yourself
6.7
Suppose an economy faces the problem of deflation caused by a decrease in aggregate
demand (from AD0 to AD1). To relieve deflationary pressure, the government can increase
government expenditure to raise aggregate demand. When aggregate demand is restored to its
original position (AD2 = AD0), deflationary pressure is eliminated and the price level is
stabilised.

PP.205-207
Exercises

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Multiple Choice Questions


1. B
Maximising profit is the goal of most private entreprises. It is not the goal of a
government which can finance its expenditure by taxation.
2.

3.

D
Within the income range of 0Y1, the curve has an increasing slope. Since the tax
payment increases by a larger percentage than the taxable income, the tax is progressive.
Within the income ranges of Y1Y2 and Y2Y3, the curve has a decreasing slope and a
zero slope, respectively. Since the tax payment increases by a smaller percentage than
the taxable income, the tax is regressive.

4.

C
To comply with the equity principle, direct taxes on income and wealth are usually
proportional or progressive. However, indirect taxes on goods and services can be
regressive, proportional or progressive.

5.

A
By raising the tax rate of a direct tax, the aggregate demand will decrease and both the
real national income and the price level will decrease in the short run.

6.

B
At taxable incomes of $10,000, $20,000 and $30,000, the average tax rates of Policy A
are 10%, 10% and 10%, respectively, and those of Policy B are 10%, 12.5% and 15%,
respectively. The change from a proportional tax to a progressive tax will cause more
even income distribution, a weaker incentive to work and slower economic growth. The
change may also reduce the tax revenue collected.

7.

D
Option A is a direct tax. Options B and C are other sources of revenue. Option D is an
indirect tax.

8.

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A decrease in government revenue is an expansionary fiscal policy while a decrease in


government expenditure is a contractionary fiscal policy. Given that they are equal in
amount, the expansionary effect of the former is weaker than the contractionary effect of
the latter. There is a net decrease in aggregate expenditure. Aggregate demand decreases,
leading to a drop in real national income in the short run.
9.

B
Option A is incorrect. The ratio increases.
Option C is incorrect. The percentage change in public expenditure and that of GDP in
times of deflation are not given. Therefore, we are uncertain as to the size of the public
sector.
Option D is incorrect. The ratio increases.

10. B
In a recession, revenues from direct taxes and indirect taxes both decrease, while
transfer payments, e.g., unemployment benefits, increase. However, we cannot
determine whether options A, C and D are correct or not as we do not have sufficient
information regarding the absolute change in GDP, tax revenues, and public expenditure
as well as percentage changes.
Short Questions
1.
The equality principle suggests that the government should tax its people according to their
ability to pay. Adam Smith suggested the imposition of a proportional tax. (1 mark)
After the imposition of a goods and services tax, most lower income earners, who are not
within the tax net of direct taxes, will fall into the tax net.
Moreover, as lower income earners usually spend a larger proportion of their income on
consumption than the higher income earners. Lower income earners pay a higher tax rate (a
larger percentage of their income is taxed and paid as tax) than the higher income earners.
This violates the equality principle. (4 marks)
The economy principle suggests that the costs incurred in tax collection and tax payment
should be minimised. (1 mark)
In order to widen the tax base, a goods and services tax is imposed on most goods and
services and borne by most consumers and firms. The administrative costs involved are

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probably larger than those involved in direct taxes. This probably may violate the
economy principle. (4 marks)

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2.
Disagree.
A tax is progressive if its (average) tax rate increases as a taxpayer's taxable income
increases. (1 mark)
Tax payment = Tax rate (Taxpayers) Income. (1 mark)
Tax payment increases with income if the
i. tax rate increases;
ii. tax rate remains unchanged;
iii. tax rate decreases but its percentage drop is smaller than the percentage rise in income.
(3 marks)
If the tax payment of a tax increases with income, the tax can be progressive, proportional or
regressive. (1 mark)
3.
a.
Possible sources
of government
revenue

Shortcomings

i. Fees from
public services

The objective of public enterprises is to serve society (e.g., take care


of the needy), instead of profit maximisation. Most public services
are provided at zero prices or prices lower than costs. The
government has to rely on other sources of revenue to subsidise
public services.

ii. Land sales

Since the supply of land is limited and the revenue from land is very
unstable, it may not be reliable for financing public expenditure.
Moreover, high land prices raise the rental and production costs of
all firms. Their profits may decrease along with the profit tax
collected by the government.

iii. Using past


fiscal surplus

Since the amount of past fiscal surpluses are limited, this cannot be
relied on to finance public expenditure. Moreover, a certain amount
of the surplus has to be reserved for emergency use.

iv. Borrowing

Borrowing has to be repaid and the government eventually has to


rely on other sources of revenue. Moreover, borrowing creates an

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interest burden.
v. Fines

The objective of fines is to deter misbehaviour and crimes. Society


prefers to have zero fines.

vi. Aid or
contributions

Aid or contribution is unstable. Most is donated to cover losses from


disasters (e.g., earthquakes) or the additional expenses from special
events (e.g., Olympic Games). Usually, the amount is insufficient to
cover losses or cover the additional expenses. Hence it cannot be
spared to finance normal public expenditure.

(2 marks each. Accept other reasonable answers.)


3 b. All of the above sources have their shortcomings and cannot be relied on to finance
public expenditures. While a government is established to serve society, it needs
resources to do so. It is the responsibility of its people to finance public expenditure.
Hence, most governments are granted the authority to tax their citizens. (5 marks)
4. A balanced budget refers to a situation where the estimated revenue equals estimated
expenditure. In other words, the government raises its expenditure by A and raises its
revenue from households through taxation by the same amount of A. (1 mark)
Note that households seldom spend the entire amount of their disposable income
(income after taxes). They usually spend a fraction (assumed to be 70%) for present
consumption and save the remaining for future consumption. (2 marks)
When the government raises its revenue to finance its expenditure by A, households
disposable income drops by A and households consumption drops by 0.7A (and their
savings drop by 0.3A). (1 mark)
The contractionary effect of an increase in government revenue by A is a drop in
aggregate expenditure by 0.7A. The expansionary effect of an increase in government
expenditure by A is a rise in aggregate expenditure by A. The contractionary effect is
weaker than the expansionary effect and a net increase in aggregate expenditure by 0.3A
occurs. Therefore, a balanced budget has an expansionary effect to an economy. (4
marks)

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Structured Questions.
1 a. Direct taxes: e.g., profit tax
Indirect taxes: e.g., rates
Other revenues, e.g., land premium
(One mark each. Accept other reasonable answers.)
1 b. i. In this case, the recovery raises both the real national income and the general price
level. As nominal GDP increases, revenues from percentage taxes (= Tax rate Sales
revenue) on goods and services increase. As real GDP increases, revenues of unit
taxes (= Unit tax Units of output) from goods and services increase too. Therefore,
indirect taxes increase. (3 marks)
When nominal income increases, if allowances and deductions remain unchanged, a
larger portion of nominal income becomes taxable. Moreover, since income taxes in
Hong Kong are either progressive or proportional, revenue from direct
taxes (= Average tax rate Taxable income) increases. (3 marks)
A recovery may also raise other revenue for the government, e.g., land premium, fees
and charges. (1 mark)
Whether the percentage share of direct tax revenue in total government revenue
increases or decreases depends on the percentage increases from different sources of
government revenue relative to each other. (1 mark)
1 b.ii. A capital gains tax on investors who gain in the stock market is a direct tax on wealth.
Its imposition raises direct tax revenue. (2 marks)
However, imposition of the tax may lower private consumption expenditure as
taxpayers have less wealth (lower ability) to consume. Hence, revenue from indirect
taxes may drop. (2 marks)
Thus, the percentage share of direct tax revenue to total government revenue
increases. (1 mark)

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1 c. i. The levy is a tax on goods and services. As its burden can be shifted from retailers to
customers, it is an indirect tax. (2 marks)
1 c. ii. Generally, higher income earners spend a smaller proportion of their income on
consumption than those in the lower income group. Moreover, their percentage
increase in expenses on plastic shopping bags is usually smaller than the percentage
increase in consumption expenditure. (2 marks)
Hence, the tax payments for plastic shopping bags must increase by a smaller
percentage than the total income of taxpayers. Since the average tax rate drops with
total income, the tax is regressive. (2 marks)
1 c. iii. Since the levy is regressive in nature, its imposition lowers the disposable income of
lower income earners by a larger percentage than that of the higher income group.
Hence, income distribution is less even. (3 marks)

2 a. Tax base refers to the scope being taxed by the government. After the increase in
personal allowances, those taxpayers whose taxable income is larger than the old
personal allowance but smaller than the new personal allowance are exempted
from paying salaries tax. Thus, the tax base is narrowed. (3 marks)
2 b. The lowest income group, whose taxable income is smaller than the old personal
allowance, does not have to pay salaries tax under the new scheme. They are not
affected. (2 marks)
Taxpayers who have to pay taxes under the old scheme and pay taxes according to
progressive tax rates under the new scheme can enjoy a tax reduction as part of their
taxable income is exempted from taxation. (2 marks)
The highest income group, who pay the standard tax rate under both the old and new
schemes, are not affected. (2 marks)
Since the low and middle income group can enjoy a tax reduction and a larger
disposable income, income distribution is more even. (1 mark)

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2 c. The increase in personal allowance lowers the tax burden of the low and middle income
groups and raises their disposable income. Private consumption expenditure increases.
Aggregate demand increases (from AD1 to AD2 or AD3 or AD4, depending on the
magnitude of the shift). (1 mark)
Furthermore, the increase in personal allowance raises people's incentive to work.
Hence, the labour supply increases and the long run aggregate supply curve shift
rightwards (from LRAS1 to LRAS2). (1 mark)
When both the AD and LRAS increase, the full employment real national income must
increase but the change in the price level will depend on the magnitude of the shift of the
AD curve relative to the LRAS curve.
If AD (from AD1 to AD2) < LRAS Yf and P (1 mark)
If AD (from AD1 to AD3) = LRAS Yf and P is unchanged (1 mark)
If AD (from AD1 to AD4) > LRAS Yf and P (1 mark)

(Changes in AD curve - 3 marks


Change in LRAS curve - 1 mark
Correct label of P and Y - 1 mark - deduct half a mark for each mistake)

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pp.207-208
Activities
1.
According to the sources provided, the amount of tax paid by Hong Kongs top 10 salaries
taxpayers and top 10 profits taxpayers in 2009-10 and their tax payment as a percentage of
the total amounts of salaries and profits tax payments are listed in the following table:
Salaries tax

Profits tax

Tax paid by top 10 taxpayers in 200910

$0.367 billion

$11.07 billion

Total amount of tax received in 2009-10

$41.2 billion

$76.6 billion

0.89%

14.4%

Top 10 taxpayers tax payment as a


percentage of total amount of tax
received

2.
Students may refer to Section 6.4 for the pros and cons of imposing direct taxes relative to
indirect taxes. The following websites are further references for discussion.
Reference:
http://www.tutor2u.net/economics/content/topics/fiscalpolicy/direct_v_indirect.htm
3.
Students may form groups and each group presents one option in the report. Students may
then discuss these options from various angles, such as whether the option broadens the tax
base of Hong Kong, satisfies the principles of taxation, can generate a stable tax revenue,
brings serious harm to the economy, etc.
4.
The budget may allocate more resources in assisting ethnic minorities integrating into local
communities, such as
providing more facilities which suit the needs of ethnic minorities in each district e.g.,
cricket field, area for their rituals;
subsidising media broadcasting programmes related to ethnic minorities.
To reduce speculative activities in the property markets, the government may
impose a capital gain tax in the property market;
regulate the mortgage prepayment penalty clause, e.g., raising the penalty rate.

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5.
Students may refer to the following sources and prepare for the debate. Students may argue
from different angles, e.g., to what extent it broadens Hong Kongs tax base, in what ways it
affects various industries, e.g., tourism and retail industries, etc.
Reference:
http://www.taxreform.gov.hk/eng/document.htm
http://www.hkpl.gov.hk/textonly/english/services/services_rlr/files/common/GST.pdf
http://en.wikipedia.org/wiki/Goods_and_Services_Tax_(Hong_Kong)
6.
Students may refer to the following sources and prepare for the debate. Hong Kong is widely
regarded as one of the freest economies in the world where government intervention in the
market is minimal. Some people argue that the big market, small government has been one
of the factors contributing to the success of Hong Kongs economy since the end of World
War II. Yet, during the financial tsunami in 2008-09, the government deployed a large amount
of fiscal reserves to stabilise the domestic economy. Students may begin their debate based
on this background.
Reference:
http://www.cato.org/pub_display.php?pub_id=7173
http://www.news.gov.hk/en/category/ontherecord/060919/html/060919en11001.htm
Big market, small government, Paragraphs 35-38, The 2010-11 Budget , HKSAR

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