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Monetary and Supply-Side Policy: Question 8

Syllabus 4.4

Structured 9 marks

Meridale's government wants to reduce structural unemployment and raise the economy's potential output. It announces two supply-side measures, both taking effect over the next three years:

  1. cutting the basic rate of income tax from 25% to 20%;
  2. relaxing employment protection laws, making it easier for firms to hire and dismiss workers (increasing labour market flexibility).

(a) Identify which of Meridale's two measures directly strengthens workers' incentive to seek paid work, and explain why. [3]

(b) Explain how making the labour market more flexible might help reduce structural unemployment in Meridale. [3]

(c) Discuss one likely limitation of relying on these two supply-side measures to reduce Meridale's unemployment rate. [3]

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Worked solution

Part (a): The measure that strengthens work incentives

Cutting the basic rate of income tax from 25% to 20% is the measure that most directly strengthens workers’ incentive to seek paid work. With a lower tax rate, workers keep a larger share of each additional dollar they earn, so the financial reward from working, compared with not working, increases.

Part (b): Labour market flexibility and structural unemployment

Relaxing employment protection laws lowers the cost and risk to firms of hiring new staff, since it becomes easier (and less costly) to end an employment contract if it does not work out. This makes firms in growing industries more willing to take a chance on workers whose skills or experience are not a perfect match for the role, including structurally unemployed workers whose previous industry has declined, helping more of them find work in expanding parts of the economy.

Part (c): A limitation of the two measures

Both measures have real limitations. Cutting income tax reduces the amount of revenue the government collects, which is an opportunity cost: the government has less money available for public services, or must accept a larger budget deficit, unless it can be made up elsewhere. Relaxing employment protection, meanwhile, removes a legal barrier to hiring but does not force firms to hire more workers. If the workers available still lack the specific skills growing firms need, or if there is simply not enough demand for firms’ output, employment may rise only modestly despite the change in the law. So neither measure guarantees a large or quick fall in Meridale’s unemployment rate.

Final answers

  • (a) The income tax cut directly strengthens the incentive to work, since workers keep more of their earnings.
  • (b) Greater labour market flexibility lowers the cost/risk of hiring, making firms more willing to take on workers affected by structural unemployment.
  • (c) The tax cut has an opportunity cost in lost government revenue, and relaxed employment protection does not guarantee firms will actually hire more, especially if a skills or demand gap remains.