A government decides to raise personal income tax rates. Using diagrams, explain one possible demand side consequence and one possible supply side consequence of this decision.
(the file that includes diagrams can be found at our wiki here)
Taxes are divided into direct and indirect where indirect are taxes on goods and on expenditures while direct are taxes on income. Personal income taxes are thus a type of direct taxation which may affect consumption and saving decisions as well as the incentive to work. (serves as a short intro paragraph that sets the framework of the answer and helps keep you focused)
Consumption is defined as spending by households on durable and non-durable goods and services per period of time. It depends on the level of disposable income which refers to income minus direct taxes plus transfer payments (i.e. pensions and unemployment benefits; Yd = Y – T + Tr).
If personal taxes increase then disposable income will decrease and thus consumption expenditures will also decrease. Aggregate demand (total spending on domestic goods & services per period of time; AD C + I + G + NX) will decrease and in the diagram below shift from AD1 to AD2. This will decrease the level of national income from Y1 to Y2 (or, slow down growth) and also may lower any inflationary pressures in the economy.
In this sense, this increase in personal income taxes may be part of a contractionary fiscal policy (could define) that aims at decreasing inflationary pressures.(this wraps up the demand side consequence)
(now the supply-side consequence)
On the other hand, this increase in personal income taxes may have an adverse effect on Aggregate Supply (the planned level of output at different average price levels per period of time) shifting AS to the left from AS1 to AS2, (see diagram) as it may create disincentives to work.
This though is not a necessary consequence as it depends on the relative size of the substitution and income effects.
(description of the substitution effect):
If personal income taxes increase, then leisure becomes cheaper and thus people will tend to substitute leisure for work (they will tend to work less)
(description of the income effect):
On the other hand, the increase in taxes will lower disposable income and thus, as leisure is a ‘normal good’, people will tend to choose less leisure and work more.
It is thus not, a priori, known whether the substitution effect will dominate the income effect and thus decrease labor supply and consequently aggregate supply.
If it does indeed decrease AS, then the capacity of the economy to produce will decrease and any increase in AD will be more likely to prove inflationary.
Lastly, it may be worth noting that as a result of the disincentives that an increase in personal income taxes may create, tax revenues collected by the government may even decrease. This is illustrated by the Laffer curve below which shows that at the higher tax rate t2, tax revenues are lower at T2.
(the usual: not a model answer - the idea of a model answer is rediculous- just some thoughts on this question that may prove helpful)
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