Question

32. Suppose the government was operating a balanced budget in the year 2025. The next year, in 2026, the government cut taxes by $20 billion.

Part 1: After the tax cut is implemented, what is the impact on public saving? Using an equation or model, explain your answer.

Part 2: Assume that all consumers believe the tax cut is going to be matched by a tax increase in the near future. As such, consumers save the full proceeds of the tax cut. What is the impact of the tax cut on private savings? Using an equation or model, explain your answer.

Part 3: Assume that all consumers believe the tax cut is permanent. As such, consumers spend the full proceeds of the tax cut. What is the impact of the tax cut on private savings? Using an equation or model, explain your answer.

Part 4: In both scenarios – (a) consumers save all of the tax cut and (b) consumers spend all of the tax cut – what is the impact on national saving? Using an equation or model, explain your answer both scenarios.

Answer 1

Ans(a) After the cut in taxes the public saving will decrease because government revenue is going to decrease by the same amount of cut in taxes. Government use their revenue in expenditure for public ,or to develop the economy. If the revenue of govt will decrease they will reduce expenditure spent on infrastructure the government multiplier will decrease. The ratio of change in income to the change in spending is the government multiplier. ∆Y/∆G

∆Y= 1/1-MPC ∆G

∆Y/∆G= 1/1-MPC

∆Y/∆G= 1/1-MPC = 1/MPS

The increase in saving will reduce the multiplier so the govt to run economy at same rate either to decrease saving or borrow from market to meet the expenses.

(b) In this case the private saving is equal to private saving. Because consumers are expecting to increase of taxes in near future. The interest will increase by the same amount of taxes. For meeting expenditure govt have to borrow from market and if govt wants to decrease or doesn't want to increase its deficit then they have earn surplus or the amount of equal to increase in interest rate.

t = 1+r ( will increase by this amount )

This will increase the effect to the public saving or private saving will increase by the same amount. The ratio of change in consumption to the change in taxes is the tax multiplier.

∆Y =( -MPC/1-MPC )∆T

∆Y/∆T= -MPC/ MPS

By this we can see that the consumption will decrease and will increase private saving.

(c) If consumer believe that tax cut is permanent then all consumer will spent their income and private saving will not get effected. Private saving will decrease or constant because consumer will spent their income on consumption of goods and service and will thought that their income has increase this will show marginal propensity to consume will increase while of private saving will decrease.

Ans (d) in case (a) consumer save all taxes cut and this will increase private saving and as result the public saving will increase as govt use their saving for the development of economy while in case (b) consumer will spent all the income on their consumption this will reduce saving now but in future this can increase the saving because of aggregate demand will increase this will effect income and in future the saving can increase of the economy.