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IAI Actuarial Core Principles · Business Economics · Supply-side policies and their impact on businesses

A government cuts the corporate tax rate and also introduces tax relief on research and development spending. Which of the following is the most likely impact on businesses, ignoring any change in government borrowing?

Lower corporate tax and R&D relief raise the after-tax return on investment, so more projects become worthwhile. Firms invest and innovate more, which expands productive capacity and shifts long-run aggregate supply outward over time.

  1. ALower after-tax returns on innovation projects, so firms cut R&D
  2. BHigher after-tax returns on investment, encouraging more capital spending and innovation, which raises long-run productive capacityCorrect
  3. CImmediate fall in the demand for the firms' products because the government spends less
  4. DA fall in the capital stock because firms prefer to distribute profits
  5. A rise in the cost of capital because equity becomes less attractive

Explanation

Lower corporate tax and R&D relief increase the post-tax return on investment projects, so more projects clear the required return. Greater investment and innovation raise productive capacity over time. The other options reverse the direction of the incentive.

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