JC Economics Essay Equilibrium Level Of National Income & Taxation Model Answers
The level of economic activity is determined by the level of aggregate demand or AD in an economy. As AD = C + I G + (X-M), any changes to the various expenditure components may change the level of AD, including taxes on households and firms.
(a) Explain in theory, how the equilibrium national income of an economy is determined, and explain what is the main factor for Singapore’s level of national income. 
(b) Discuss how the shift away from direct towards indirect taxes might affect the S’pore economy. 
Determination of the Equilibrium Level of National Income in an Economy
Suggested Answer Part (a)
Equilibrium level of national income is defined as the level of national income that has no tendency to change. It is achieved when aggregate expenditure (AE) is equal to the national income in the economy. This essay will aim to explain how the equilibrium level of national income is reached using the income expenditure approach.
3 main points:
Topic Sentence (usually involves the economic concept to be used)
Explain (the economic concept)
Exemplify (using examples)
(*remember to answer the question)
1. Define AE & its components
AE refers to the desired expenditure on domestically produced goods and services at each level of national income. It consists of consumer expenditure (C), investment expenditure (1), government expenditure (G) and net exports (X-M).
2. Explain the approach used (Y=AE)
The income-expenditure approach to income determination states that in an open economy with a government sector at equilibrium income (Y) = aggregate expenditure (AE) where AE = C+I+G+(X-M). Investment (1), government expenditure (G) and the value of exports (X) are assumed to be autonomous, i.e. independent of the level of income. The income-expenditure diagram can be used to show how equilibrium national income is determined. In this diagram, we use the 45° degree line to indicate the values where national income aggregate expenditure.
3. Show disequilibrium national income when Y<AE & Y>AE
In Figure 1, we see that when national income is at $500b, planned AE exceeds planned output. This means that goods and services are being bought at a faster rate than they are being produced. There will be unplanned disinvestment or a fall in unplanned inventories (stocks). When firms see this, they take steps to expand output hiring more workers. This will cause output, income and employment to rise. National income will then rise until the equilibrium position E is reached when planned AE equals planned output. On the other hand, if national income is at $700b, planned output exceeds planned AE. This means that firms find their sales are less than expected. There will be unplanned investment or a rise in unplanned inventories, causing firms to cut back on production and laying off workers. This results in a drop in income, employment and output. National income will fall until equilibrium position E as shown in Figure 1.
As such, equilibrium national income occurs where AE, made up of consumption, investment, government expenditure and net exports, equals to national income.
(Note: for the new H2 Syllabus, the above Income – Expenditure approach is not required. You are advised to use the AD-AS Approach. Sketch the AD-AS diagram as an exercise.)
For the SG economy, she has a small domestic market and a large external demand, so the component of (X-M), aka net exports is the largest. X usually increases as our trading partners experience a growing income levels in an economic boom, as demand for our export rise, thus export revenue increases.
Taxation & Impact on the Equilibrium Level of National Income in Singapore
Introduction: Explain taxes as a policy instrument of fiscal policy
Thesis: Positive Impacts on SG Economy
Eg: lower personal tax rates and corporate income tax rates in SG, and higher Goods and Services tax (GST). Such a shift from lower direct axes to higher indirect taxes is to shift the tax base, which will change the tax incidence and of course the tax burden.
Overall, C and I may rise rises in net terms, so higher AD, multiplier effect, so equilibrium national income of Singapore increases, implying higher actual growth rates.
Thesis: Negative Impacts on SG Economy
Higher taxes, thus, cost-push inflation worsens, as now costs of production (COP) rise.
With more incomes, household and firms may purchase more from overseas, as our marginal propensity to import (MPM) is high. Hence, demand for imports is high, and so may worsen balance of trade (BOT).
Depends on magnitude of tax rate changes
Depends on how fast consumers spending pattern change
Depends on expectation of future tax changes, whether expected changes is temporary or permanent, etc.
(More evaluation skills on our H2 Essay tuition classes.)
Do attempt to draw your own conclusions. Is tax shift better or worse off? In which areas?
(More on Income Tax Act in S’pore.)