Taxation, government spending and the business cycle

Taxation

• Taxes on income: higher income tax cuts consumers' disposable income and spending.
• Corporation tax (tax on company profits): a higher rate leaves less retained profit for investment and dividends.
• Indirect taxes (VAT or sales tax, excise duties on fuel, alcohol, tobacco): raise prices; the impact on sales depends on price elasticity.
• Employment taxes paid by employers raise labour costs.

Tax cuts generally do the opposite, boosting spending or profit.

Government spending

Government spends on health, education, infrastructure, defence and welfare.

• Firms that supply the government (construction, IT, medical supplies) gain directly from higher spending.
• Spending on infrastructure (roads, broadband, ports) cuts costs for all firms.
• Welfare spending supports demand in a downturn.

Cuts in spending can hit suppliers and reduce demand across the economy.

The business cycle

The economy fluctuates around its long-term growth trend through four phases:

• Boom: high demand, rising prices and wages, capacity stretched, shortages of skilled staff.
• Downturn (slowdown): growth slows, demand weakens.
• Recession: falling output, rising unemployment, falling demand, business failures. Often defined as two consecutive quarters of falling real GDP.
• Recovery: demand and confidence return, unemployment falls.

The impact depends on the product: demand for luxury and income-elastic goods (holidays, restaurant meals, new cars) swings strongly; demand for necessities is steadier, and discount retailers may even gain in a recession.

Responding to the cycle

In a recession firms may cut costs, reduce prices, delay investment, shift to cheaper product lines or seek export markets. In a boom they may raise prices, expand capacity and invest. Good planning, such as building cash reserves in a boom, helps firms survive downturns.

Worked example

A restaurant chain and a discount supermarket chain both face a recession. Compare the likely impact.

1. Restaurant meals are a luxury with high income elasticity, so sales fall sharply as incomes and confidence drop.
2. The discount supermarket sells necessities at low prices; households trading down from dearer shops may increase its sales.
3. Response: the restaurant may cut prices or introduce set-price menus; the supermarket may expand.

Answer: The restaurant suffers more; the discounter may benefit.

Check yourself

1. A product's price before sales tax is $80. Sales tax is 20%. What is the price including tax?
   Show answer

   $96. 80 x 1.20 = $96.

2. A company's profit before tax is $500,000. Corporation tax rises from 19% to 25%. By how much does its tax bill rise?
   Show answer

   $30000. 500,000 x 0.06 = $30,000.

3. Profit before tax is $500,000 and tax is 25%. The company pays $150,000 in dividends. How much profit is retained?
   Show answer

   $225000. Profit after tax 375,000 - 150,000 = $225,000.

4. Which problem is a business most likely to face in a boom?
   • Falling demand for luxury goods
   • Shortages of skilled workers and rising wage costs
   • Rising unemployment among customers
   • Excess spare capacity
   Show answer

   Shortages of skilled workers and rising wage costs. Demand is high, so resources are scarce.

5. Which business is likely to be least affected by a recession?
   • A luxury car dealer
   • An overseas holiday company
   • A builder of new homes
   • A supplier of basic food items
   Show answer

   A supplier of basic food items. Demand for necessities is steady.

6. A government increases spending on road building. Which business benefits most directly?
   • A luxury fashion retailer
   • A construction company
   • A cinema
   • A mobile phone app developer
   Show answer

   A construction company. It wins contracts directly.

7. A rise in income tax is most likely to
   • raise firms' corporation tax
   • lower the price of goods
   • increase consumer spending
   • reduce consumers' disposable income and spending
   Show answer

   reduce consumers' disposable income and spending. Less take-home pay means less spending.

8. Explain how a recession might affect a business selling holidays.
   Show answer

   In a recession incomes fall and unemployment rises, so consumers cut spending on luxuries such as holidays; sales and profit fall and the business may need to cut prices or costs.. Falling incomes and confidence cut demand for luxuries like holidays, so sales and profit fall.

Practise with instant feedback Print this lesson

Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.