Currently, the output level of Country X is below the full-employment output level.

To tackle the

problem, the government is considering adjusting the profits tax rate.

(a) Explain whether the government should raise or lower the profits tax rate. (2 marks)

(b) With the aid of a diagram, explain how the adjustment in the profits tax rate helps the economy to

restore full-employment output level. (7 marks)

##

(a) When the output level is below the full-employment output level, there is a deflationary gap. The

government should therefore lower the profits tax rate to raise the aggregate demand and the

output level. (2 marks)

(b) When the profits tax rate decreases, the incentive for firms to invest will increase and firms will

increase their investment expenditure. Aggregate demand will increase and the AD curve will shift

to the right from AD0 to AD1. (2 marks)

The price level will increase from P0 to P1 and the output level will increase from Y0 to Y1. The

full-employment output level is restored. (2 marks)

Price level
LRAS
SRAS

P1
P0

AD0 AD1

0 Y 0 Y1 Quantity of output
(real GDP)

(3 marks)

Suppose an economy is suffering from serious inflation and the current output level is higher than the

full-employment level. The government plans to increase the personal allowance of the salaries tax in

order to alleviate the problem of inflation. Can the measure alleviate the problem of inflation? Explain

with the aid of a diagram. (7 marks)

##

The measure cannot alleviate the problem of inflation. (1 mark)

When the government increases the personal allowance of the salaries tax, people’s disposable income

will increase. Private consumption expenditure will increase. Aggregate demand will increase and the

AD curve will shift to the right from AD0 to AD1. (2 marks)

The price level will increase from P0 to P1. The problem of inflation will worsen. (1 mark)

Price level
LRAS

SRAS

P1
P0

AD1
AD0

0 Y0 Y1 Quantity of output
(real GDP)

(3 marks)

In the 2012-13 Budget, the Financial Secretary proposed to increase several allowances for the salaries

tax, including an increase in basic allowance from $108,000 to $120,000 and an increase in married

person’s allowance from $216,000 to $240,000.

(a) Explain whether the salaries tax is a direct tax or an indirect tax. (2 marks)

(b) With the aid of an AS-AD diagram, explain how the above proposal would affect Hong Kong’s

price level and real GDP in the short run. (6 marks)

##

(a) Direct tax. (1 mark)

It is because the tax burden of the salaries tax is borne by the party being taxed and cannot be

shifted to other parties. (1 mark)

(b) When the government increases several allowances for the salaries tax, people’s disposable

income will increase. Private consumption expenditure will increase. Aggregate demand will

increase and the AD curve will shift to the right from AD 0 to AD1. (3 marks)

In the short run, the price level will increase from P0 to P1 and real GDP will increase from Y0 to

Y1. (1 mark)
 Price level

SRAS

P1
P0
(2 marks)
##
@@a)nil,2@@
@@b)nil,6@@ AD1
AD0
[[]] 0 Y0 Y1
Quantity of output
(real GDP)

Question 1
Suppose a country faces the problem of unemployment and trade deficit.
(a)With the aid of a diagram, explain how the government can solve the problem of unemployment by
increasing transfer payments. (9 marks)
(b)Explain whether the policy in (a) would hep reduce the trade deficit. (4 marks)

Question 2
(a) With the aid of a diagram, explain how the sharp rises in input prices will affect the equilibrium
price level and output in the short run. (5 marks)
(b) Suppose the government aims to stabilize output in the short run by fiscal policy. Use an example
of fiscal policy to show how the government could achieve its objective. How would such policy
affect the price level? Explain your answer with the aid of a diagram. (6 marks)
(c) Suppose the government aims to stabilize the price level in the short run by fiscal policy. Could
the government achieve its objective? How would such policy affect the level of output? Explain
your answer with the aid of a diagram. (6 marks)
(d) Based on your answers to the above questions, explain whether there is a trade-off between the
objectives of stabilization of output and stabilization of price level. (3 marks)
Question 3
Consider an economy originally situated in both short-run and long-run equilibrium. To encourage
investment, the government reduces the profit tax rate for all business.
(a) Explain how the reduction in the profit tax rate will affect the aggregate demand as well as the
short-run aggregate supply of the economy. (4 marks)
(b) With the aid of a diagram, explain how the reduction in the profit tax rate will affect the
 equilibrium output in the short run. Under what condition will the equilibrium price level
increase? Explain. (5 marks)
(c) Suppose the price level increases in the short run as in (b) above. With the aid of the diagram, you
used in (b), explain how, in the long run, the equilibrium price level and output will be different
from that in (b). (6 marks)
Question 4
(a) With the aid of a diagram, explain how the decrease in property prices will affect the equilibrium
 price level and output of the economy in the short run. (7 marks)
(b) In response to the decrease in property prices, suppose the government reduces the profits tax rate.
(i) Explain how a reduction in the profit tax rate would affect the aggregate demand. Based on
your answer, could such policy restore the price level and the level of output to that before the
decrease in property prices? (4 marks)
(ii) A reduction in the profit tax rate may also affect firms’ return from production, and thus their
incentive to supply output. Explain how this change in incentive will affect the short-run
aggregate supply. With the aid of a diagram, explain whether such policy could restore the
price level and the level of output to that before the decrease in property prices. (10 marks)
Question 5
Consdier an economy facing the problem of unemployment, Suppose the government aims to achieve full
employment by increasing its expenditure.
(a) Suppose the government finances the increase in expenditure by collecting a lum-sum tax on each
household. Could the government achieve its objective? Explain your answer with the aid of a
diagram. (12 marks)
(b) Suppose the government finances the increase in expenditure by increasing the income tax. With
the aid of a diagram, explain why the government may not be able to achieve its objective? (9
marks)
Question 6
A government facing a budget deficit may consider raising tax rates or introducing new taxes to raise tax
revenue.

(a) Explain why an increase in the salaries tax rate may not necessarily increase the tax revenue of the
government. (4 marks)
(b) Introducing a general sales tax is an alternative to reduce the budget deficit.
(i) With the aid of a diagram, explain how an introduction of a general sales tax would affect the
output level of the economy.
(ii) Explain whether introducing a sales tax will necessarily increase the tax revenue of the
government.
(c) Apart from budget balance, the government may have other objectives. Which policy, raising
salaries tax rate or introducing a general sales tax, would you recommend if the government’s
objective is to
(i) Reduce income inequality? (5 marks)
(ii) Maintain stability in tax revenue? (5 marks)
Explain your answer.