Question

1. Those who favor increases in tax rates are often disappointed that the additional revenue turns out to be less than expected. Conversely, those who fear that cuts in tax rates will substantially reduce the government’s revenues have often been surprised to find the government’s revenues rising. Explain both of these phenomena.

Answer 1

Increase in tax rates often results in less than expected increase in revenue. This is because it results in a slowdown fo the economy. As people are left with less disposable income, they reduce their consumption and hence there is a negative demand shock. if the negative multiplier is large, the slowdown in the economy in the short-medium run can be substantial. Since tax revenue = tax rate*Income, If income is falling as the tax rates decrease, the total increase in the tax revenue will be hampered.

Similarly, a decrease in taxes can often produce higher tax revenues. As people's disposable income rises, this positive income shock translates into a positive demand shock and sets the economy in motion. The positive multiplier can be large enough to raise the incomes in the economy substantially in the short-medium run. Thus if Y increases by more than a decline in tax rate, the tax revenues can actually increase.