Question

The Trump administration Tax Cut and Job Act lowered corporate tax from

35% to 21%. The Act also lowered individuals and households tax rate. Using the

long-run model of the economy developed in Chapter 3, State in words what happens

to: i. the real interest rate; ii. national saving; iii. investment; iv. consumption; and

v. output. (15 pts)

Answer 1

To understand how the corporate tax cut and household tax cut will affect the economic variables we need to understand how that tax cut is going to affect the individual firm's and household's consumption and saving decisions.

Let's see what a corporate tax cut would mean for firms, a lower tax rate means they will be paying less amount in taxes and as a result the probability of firms in economy will increase. Which implies that the firm's will have more profit in hand as compared to the case when tax rate were higher, now the firms can either choose to consume this amount or choose to increase investment and savings.

Similarly, when household tax rates are lowered they'll have more money in hand which is disposable income. Now with increased income they can either choose to consume the entire extra income or choose to save the entire extra income. But we know the households only consume a fraction of their income which is marginal propensity to consumer (MPC) and they save the rest of the income.

So now we know that, lower tax rate means higher disposable income for households and higher profit for firms. Now let's see how this will manifest itself itself on economic variables.

(ii) Let's first see the impact on national savings. As we saw earlier reduced tax rate means higher income and profit which means higher consumption and savings. So we can say for sure that the national savings will increase in the long run after the tax rate reduces.

(i) Now let's see what happens to real interest rate. The real interest rate in any economy is decided by the market forces of demand and supply of loanable fund. The supply of loanable fund is the national savings in the economy and demand is the demand for investment which is a function of real interest rate. So when savings increases in the economy the supply of loanable fund in the economy increases as a result for a given demand for loanable fund the real interest falls. So we can that the real interest will fall in long run in the economy.

(iii) As we know the demand for investment is a function of real interest rate. As the real interest falls the demand for investment increases and as real interest increases the demand for investment falls. And we already know from above part that real intrest rate is going to fall and as a result the demand for investment will increase.

There is another way to look at it. As household tax rate is reduced, as a result now the households will demand more of goods and services. So the firms in the economy will react to it and invest in production facilities to support the higher demand in future. So this way also the investment must increase.

(iv) As we already discussed earlier that higher disposable income will means that households in the economy now have more money to consume. So the household tax rate reduction will lead to increased consumption demand in the economy on account of higher disposable income.

(v) Now having discusses the first four parts we easily answer the last part. We know that national income or output is simply equal to the,

Y = C + I + G + NX

Here Y = national income/Output

C = Private consumption

G = Government expenditure

I = investment demand

NX =net exports

As we have already seen above that the investment and consumption will increase in the US economy in long run. So we can say for sure that the output in the US economy will increase in the long run on account of higher consumption and investment.