Saturday, May 2, 2009

On the demand and supply side effects of increasing personal income taxes

Pointers on another interesting short: discussing possible effects on the demand and the supply side of an economy of increasing personal income taxes.

(caveat: not a model answer; just some thoughts)

This is the question:
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.

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 decisions as well as the incentive to work. (serves as a short intro 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 con-tractionary fiscal policy that aims at decreasing inflationary pressures.
(this wraps up the demand side consequence)

The rest can be found at our wiki here.

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