Question

A national economy has (relatively) graduated, progressive taxation and provides income transfers to its poorest and most vulnerable members. It enacts legislation that reduces the highest marginal tax rates and limits the scope and scale of income transfers nationally and locally. Ceteris paribus, discuss: a) The effect on Aggregate Demand b) The effect on business expectations c) The effect on consumer spending in the short and the long term, and, therefore, d) The expected change to each domestic element of GDP (that is, excluding Net Exports).

Answer 1

a) Aggregate demand will thus increase as the level of disposable income will increase as the marginal tax rates falls. This causes the aggregate demand to rise.

b) As the marginal tax rates fall, this will mean that businesses will find it more profitable to invest and so business expectations to improve as the business environment improves.

c) In the short run the level of consumption spending will increase as the disposable income rises. This will cause the aggregate demand curve to shift rightwards. In the long run the level of consumption spending will adjust back to its original levels over time.

d) As the marginal tax rate falls the consumption and investment levels will increase as people want to spend more. The level of government spending will remain unchanged. The balance of trade is likely to worsen. Given the marginal propensity to import the imports will rise and so the balance of trade worsens.