Examine the likely impact of the ‘freeze in income tax thresholds’ on aggregate demand

Edexcel A-Level Economics Paper 2 June 2024 Extract

With reference to Figure 4 and Extract A, examine the likely impact of the ‘freeze in income tax thresholds’ (Extract A line 1) on aggregate demand. (8 marks)

A freeze in income taxes is likely to cause a decrease in aggregate demand since this makes it harder for people to earn more real disposable incomes. This is because cost of living has been increasing with inflation, which means that people must bargain for payrises. As people get their payrise, more of their pay is being taxed, as many of the tax thresholds have remained the same despite ongoing inflation, and they are likely to be frozen until 2031 at least. This means that many peoples' pay is growing slower than average prices. A slow growth in real incomes can cause consumer confidence, and therefore consumer spending to fall. This causes aggregate demand (C+I+G+(X-M)) to fall, as shown below.

However, aggregate demand might not fall as much as we expect. Firstly, higher income tax payments and lower real incomes might increase people's marginal propensity to consume, which just meanst that people are more likely to spend a greater proportion of their payrise. Additionally, the government are likely to spend much of the tax revenue on services that also contribute to aggregate demand.

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