Question

3. What is the long-run effect of the increased taxation on output and the price level?

Answer 1

The following is the long run effect of the increased taxation on output and price level:

Taxes can affect both supply and demand sides. Reducing marginal tax rates on wages and salaries can induce people to work more. Similarly, higher marginal tax rates can induce people to work less.

Higher tax rates on assets such as interest, dividents and capital gains can discourage people to save more.

Higher tax rates can also lead to companies investing abroad rather than investing domestically.

Now, all these effects can lead to lower aggregate demand in the economy in the long run. The price levels will also lower due to lesser aggregate demand in the economy.

The taxation will also have budgetary effects in the economy. Higher taxes can reduce budget deficits and borrowing of the government which can prevent the crowding out in the economy and enhance investment which will lead to higher output and higher price levels (due to increased economic activity).

The net effect will depend on which effect dominates in the long run. If the budgetary effect is more than the effects discussed in the beginning, the output and price level will rise in the long run. Otherwise, the output and price level will fall.