Question

1. While your country has an open capital account, your financial markets remain imperfectly integrated with those of the rest of the world. The central bank in your country targets the stock of domestic credit. One day, an IMF team arrives and convinces the Finance Minister that your country’s fiscal deficit is excessive. The Finance Minister persuades the parliament to pass a tax increase to reduce the deficit. Explain what effect you would expect this measure to have on:

   1. The aggregate price level and level of real GDP.

   2. The level of employment and the real wage.

   3. The level of exports, of imports, and of net exports.

Answer 1

- When the government adopts concretionary Fiscal policy it results in Increasing tax rates or cutting its spending or both. When it adopts measure of increasing tax rates to finance its deficit it adversely affects the economic activities.

The aggregate demand contracts, the price level drops, the disposable income with the people decreases thus reducing their purchasing power and their consumption, it deters investment by the producers due to decrease in consumption and increased tax rates which increases their tax liability and hence with increased liability they will not make new investments which could have created new employment opportunities and increased the long term production capacity which would have boosted long term supply. The national output falls when consumption and production drops due to increase in tax rate. Tax rate increase results in the price level to fall and if there is any inflationary gap it closes. Price level falls with the decrease in aggregate demand. Individual consumption, investment by companies reduces when the tax rate increases thus resulting in the fall of aggregate demand and price levels.

Hence both Real GDP and price level fall with the increase in tax rate.

- The level of employment and wage is adversely affected with the increase in Tax rates and this is due to fact that as the tax rate increases the tax liability of the producers increases and with the increase in liability and out of hand expense of increased tax, they will restrain themselves from making any new investment, which could have expanded their production capacity resulting in increase in the long term supply, creation of new jobs. Any prospect of increasing the wage level attracting new labor force will be grim as the increased tax rate will increase the expenditure of the companies they will adopt austerity measures and refrain from making any additional expenditure on labor or physical assets. The real wage of the labors will decrease as they would have to pay increased income tax and on the other hand the increased corporate tax closes the possibility of increase in the wage.

Hence the Real wages fall and the employment level falls as the companies tax liability increases from increase in the tax rate they will refrain from spending in other avenues.

- The level of exports fall when the government increases the tax rate as the tax liability increases the expenditure of the exporters increases contracting their liquidity. When production becomes a costly affair due to increase in the tax rate the exporters will transfer this  burden of increased expenditure due to the tax rates to the consumers and when that happens the consumers in other nations will not be willing to bear the burnt, they will shift to exporters in other nations to meet their demands. Thus exports contract with increase in tax rates as it constraints exporters liquidity and inflates the expenditure resulting in low exports.

- The level of imports will increase as the domestic producers struggle with increased tax rates they will ultimately transfer this increase in the tax burden to the consumers. And domestic consumers in order to escape from this burden will prefer to purchase goods from other nations to meet their demand. Thus imports will increase with increase in the tax rate.

- The net export will decrease with increase in tax rates as the exports will contract and import will expand.Thus adversely affecting the GDP.

Tax rate increase is detrimental to the economy in all fronts- Consumption, Production, Employment, Foreign trade. The economic activities, aggregate demand, price levels all face a slump and face grim prospects with rise in tax rates.