What Effect Would a Tax Increase Have on Income

Regime’s Unique Situation

Equally you lot know, if whatsoever chemical element of the C + I + G + (Ex – Im) formula increases, and then Gdp—total need—increases. If the “G” portion—government spending at all levels—increases, then GDP increases. Similarly, if government spending decreases, then Gross domestic product decreases.

When information technology comes to financial management, iv characteristics of the government set it apart from households and businesses (the “C” and “I” in the formula):

• Authorities has the ability to tax, which gives information technology greater control over its revenue. Federal, state, and local governments tin can mandate higher taxes and increase their revenues. Households and businesses have the more difficult task of selling their labor, goods, and services in lodge to enhance revenue.
• By increasing or decreasing taxes, the government affects households’ level of disposable income (after-taxation income). A tax increase will decrease dispensable income, considering it takes money out of households. A tax decrease will increase disposable income, because it leaves households with more money. Disposable income is the main factor driving consumer need, which accounts for ii-thirds of full demand.
• The federal government can finance budget deficits past borrowing in the financial markets. Investors consider U.S. government bonds to be take a chance free, considering they are backed by the taxing power of the government. States and cities also issue bonds to finance deficits. These bonds, notwithstanding, are considered riskier considering the
  tax base of operations
  of the state or city could erode.
• The federal authorities—and merely the federal government—can impress more money. Similar raising taxes, this has potential economic consequences (in the form of higher inflation) also as political consequences. Nevertheless, the federal government does have that option, which is certainly not open to households and businesses.

These unique characteristics set the government autonomously from the other players in the economic system. They also position the federal government to formulate and implement economic policy.

Fiscal Fundamentals

Fiscal policy is the full general name for the federal government’south tax and expenditure decisions and activities, especially every bit they touch the economic system. (Monetary policy refers to policies that affect interest rates and the money supply.)

Figure 13.1 shows how C + I + G add upward to determine the equilibrium level of GDP. (For convenience, nosotros’re assuming that net exports (Ex – Im) are zero.) Line “C” represents consumption by consumers. Line “C+I” represents consumption by consumers plus investment by businesses. Line “C+I+G” represents consumption plus investment plus government spending.

The 45 degree line shows all the points at which total spending equals gross domestic product. At any bespeak on that line, the quantity demanded past the households, businesses, and government in the economic system (total spending) equals the amount existence produced (GDP). Whenever total demand equals total spending, the economy is in equilibrium.

Where is the actual equilibrium point for the economy? Where the full demand of households, businesses, and authorities—C + I + G—equals their production. That equilibrium point occurs where the line C + I + G intersects the 45 degree line. At that betoken, which is point “E” on the chart, total spending (total demand) and total production (GDP) are equal.

What About Taxes?

Figure xiii.1 ignores taxes, but they are a crucial element in fiscal policy.

Taxes lower households’ disposable income. The amount collected in taxes doesn’t find its mode into consumption (“C”). But if the government spends every dollar that it collects in taxes, then that corporeality does find its way into total demand through authorities expenditures. When that occurs, the GDP remains unaffected past taxes. The size of the economy is the same whether people choose to produce and swallow private goods (angora sweaters) or public appurtenances (army uniforms). The mix of goods doesn’t bear upon the level of Gross domestic product, as long as the total corporeality spent on them doesn’t change.

What happens when the authorities collects more in taxes than it spends?

Total spending—and therefore the equilibrium level of GDP—decreases. Suppose that the money for army uniforms is collected simply not spent. In that case, there’s no need to industry the uniforms, no demand to staff the compatible factory, and no need to pay the workers, who now take less income to devote to consumption.

In general, when the government brings in more in taxes than information technology spends, it reduces disposable income and slows the growth of the economy. And so, the fiscal policy prescription to stabilize an overheated economic system is higher taxes.

In times of inflation—when likewise much demand is bidding up prices—a tax increase, coupled with no increment in government spending, volition dampen the upward pressure on prices. The tax increment lowers need by lowering disposable income. As long every bit that reduction in consumer demand is not offset past an increase in authorities need, total demand decreases.

A decrease in taxes has the opposite consequence on income, need, and GDP. It volition boost all three, which is why people cry out for a tax cut when the economy is sluggish. When the regime decreases taxes, dispensable income increases. That translates to college demand (spending) and increased production (GDP). And then, the financial policy prescription for a sluggish economy and high unemployment is lower taxes.

Spending policy is the mirror paradigm of tax policy. If the government were to keep taxes the same, but decrease its spending, information technology would have the same effect every bit a tax increment, but through a slightly different aqueduct. Instead of decreasing disposable income and decreasing consumption (“C”), a decrease in government spending decreases the “Grand” in C + I + One thousand direct. The lower demand flows through to the larger economic system, slows growth in income and employment, and dampens inflationary pressure.

As well, an increase in government spending will increase “Yard” and boost demand and production and reduce unemployment.

Those are the fundamentals of financial policy, and they are summed up in Effigy xiii.ii.

To dampen economical growth and inflationary pressure, the authorities can increase taxes and go on spending abiding, or decrease spending and keep taxes constant. To stimulate growth and reduce unemployment, the authorities can decrease taxes and keep spending constant, or increase spending and proceed taxes constant.

Finally, the government can pursue its fiscal policy objectives more aggressively past simultaneously adjusting both taxes and spending. For example, in a sluggish economy, the authorities could decrease taxes
and
increase spending at the aforementioned time. Each could be adapted either by modest amounts, so that neither taxes nor spending are changed also radically, or by large amounts to deliver a stronger dose of fiscal stimulus. Similarly, in an overheated economic system, the government could increase taxes
and
decrease spending, if it wanted to dampen growth (and enrage voters).

Other Issues in Fiscal Policy

To keep things unproblematic, the previous section omitted 3 other aspects of financial policy: the automatic stabilizing influence of financial policy, the multiplier effect, and the propensity to spend or salve.

First, fiscal policy exerts an automated stabilizing outcome on the economy, fifty-fifty when the regime makes no explicit changes in its tax or spending plans.

When the economy contracts, revenue enhancement receipts automatically decrease (because incomes subtract). This effect is magnified past progressive tax, our organization applying higher revenue enhancement rates to college incomes. Workers who are laid off or lose their overtime pay automatically fall into a lower tax bracket. Their lower taxes bills will partially starting time the upshot of their lost income. Similarly, when incomes rise, specially during inflation,
bracket creep
pushes people into college tax brackets. The higher taxes they pay takes money out of their pockets—money they can no longer utilize to bid prices up even higher.

Regime spending also acts equally an automated stabilizer, especially during downturns. The federal government tends to maintain its general level of spending during recessions, which ensures a solid baseline level of demand from the “M” in C + I + G. As well, programs of unemployment insurance and public assistance assist to ease the burden of tough times on households.

Second, the multiplier will boost the effect of an increase or reduction in taxes or spending. For case, an extra dollar of government spending will period through the economy and, by beingness repeatedly respent, will magnify the stimulus provided by that incremental dollar. Likewise, a dollar of reduced spending will take a dollar out of the economy, and the multiplier applies to that equally well.

Finally, like the multiplier, the propensities to spend and to salve are at work. If the authorities reduces taxes to stimulate consumption, but households save the coin rather than spend it, consumption will not rising, nor will investment. If people save the money, they are “sitting on their wallets” and consumption remains low. If consumption is low, businesses won’t invest. This has been a problem in the application of fiscal stimulus in Japan, where people tend to save increases in income.