Question

In: Economics

Assume you are an economic advisor for the President. The economy is in a recession, similar...

Assume you are an economic advisor for the President. The economy is in a recession, similar in magnitude to the Great Recession of 2007. The President wants to cut income taxes. An article published in an economics journal found the following: “For the poorest households, the marginal propensity to consume was close to 70%. For the richest households, the MPC was only 35%.” (Atif Mian and Amir Sufi, “Who Spends Extra Cash?” House of Debt, April 13, 2014).

Based upon this information, what advice would you give the President about cutting income taxes? Do you recommend decreasing taxes the same amount for each group of taxpayers? Please explain and demonstrate your answer with numbers.

Solutions

Expert Solution

Based on the information that the lower income people are spending more i.e. have a higher Marginal propensity to consume than the higher income people I would advise the President to keep progressive tax rates which increases as the income increase.

For example, a poor household is earning $100 and they are spending 70% of their income. That means they are spending $70 dollar on every $100 dollar they are earning and The people have an MPC of only 35% that means they are spending only $35 from every $100 they are earning.

If we cut the tax rates equally for both income groups then the expenditure of the low-income house will increase but the expenditure form the high-income household will not. So, it will be better to tax the high-income household more than the lower income households. If high-income people get a tax cut they will only save more and if the low-income households get a tax cut they will spend more.

In the situation of recession, we need more expenditure so low-income people should be given a bigger tax cut.


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