Question

Although personally one may benefit from the recent tax reductions act, the debates among economists never stop. (1)Suppose the economy is under recession. How would a cut in taxes affect output(Y), price level (P), and unemployment (U)? Please use the models and explain your reasoning. Be sure to state the assumptions clearly. (2) In recent decades, macroeconomics policy-making process has been strongly influenced by a theory called "supply side economics". Why some economists are against it? why some support it? Please answer this question by summarizing the assigned articles in blackboard under "Fiscal Policy"

Answer 1

Expansionary fiscal policy increases the level of aggregate demand, through reductions in taxes. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investments by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services.

Consider first the situation in Figure 2, which is similar to the U.S. economy during the recession in 2008–2009. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as indicated by the LRAS curve. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.

Expansionary Fiscal Policy. The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of potential GDP which is shown by the LRAS curve. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.

The term “supply-side economics” is used in two different but related ways. Some use the term to refer to the fact that production (supply) underlies consumption and living standards. In the long run, our income levels reflect our ability to produce goods and services that people value. Higher income levels and living standards cannot be achieved without expansion in output. Virtually all economists accept this proposition and therefore are “supply siders.”

“Supply-side economics” is also used to describe how changes in marginal tax rates influence economic activity. Supply-side economists believe that high marginal tax rates strongly discourage income, output, and the efficiency of resource use.

An increase in marginal tax rates adversely affects the output of an economy in two ways. First, the higher marginal rates reduce the payoff people derive from work and from other taxable productive activities. When people are prohibited from reaping much of what they sow, they will sow more sparingly. Thus, when marginal tax rates rise, some people—those with working spouses, for example—will opt out of the labor force. Others will decide to take more vacation time, retire earlier, or forgo overtime opportunities. Still others will decide to forgo promising but risky business opportunities. In some cases, high tax rates will even drive highly productive citizens to other countries where taxes are lower. These adjustments and others like them will shrink the effective supply of resources, and therefore will shrink output.

Second, high marginal tax rates encourage tax-shelter investments and other forms of tax avoidance. This is inefficient. If, for example, a one-dollar item is tax deductible and the individual has a marginal tax of 40 percent, he will buy the item if it is worth more than sixty cents to him because the true cost to him is only sixty cents. Yet the one-dollar price reflects the value of resources given up to produce the item. High marginal tax rates, therefore, cause an item with a cost of one dollar to be used by someone who values it less than one dollar. Taxpayers facing high marginal tax rates will spend on pleasurable, tax-deductible items such as plush offices, professional conferences held in favorite vacation spots, and various fringe benefits (e.g., a company luxury automobile, business entertainment, and a company retirement plan). Real output is less than its potential because resources are wasted producing goods that are valued less than their cost of production.

Critics of supply-side economics point out that most estimates of the elasticity of labor supply indicate that a 10 percent change in after-tax wages increases the quantity of labor supplied by only 1 or 2 percent. This suggests that changes in tax rates would exert only a small effect on labor inputs. However, these estimates are of short-run adjustments. One way to check the long-run elasticity of labor supply is to compare countries, such as France, that have had high marginal tax rates on even middle-income people for a long time with countries, such as the United States, where the marginal rates have been persistently lower. Recent work by edward prescott, corecipient of the 2004 Nobel Prize in economics, used differences in marginal tax rates between France and the United States to make such a comparison. Prescott found that the elasticity of the long-run labor supply was substantially greater than in the short-run supply and that differences in tax rates between France and the United States explained nearly all of the 30 percent shortfall of labor inputs in France compared with the United States. He concluded:

I find it remarkable that virtually all of the large difference in labor supply between France and the United States is due to differences in tax systems. I expected institutional constraints on the operation of labor markets and the nature of the unemployment benefit system to be more important. I was surprised that the welfare gain from reducing the intratemporal tax wedge is so large.

The supply-side economic policy of cutting high marginal tax rates, therefore, should be viewed as a long-run strategy to enhance growth rather than a short-run tool to end recession. Changing market incentives to increase the amount of labor supplied or to move resources out of tax-motivated investments and into higher-yield activities takes time. The full positive effects of lower marginal tax rates are not observed until labor and capital markets have time to adjust fully to the new incentive structure.

Because marginal tax rates affect real output, they also affect government revenue. An increase in marginal tax rates shrinks the tax base, both by discouraging work effort and by encouraging tax avoidance and even tax evasion. This shrinkage necessarily means that an increase in tax rates leads to a less than proportional increase in tax revenues. Indeed, economist Arthur Laffer (of “Laffer curve” fame) popularized the notion that higher tax rates may actually cause the tax base to shrink so much that tax revenues will decline, and that a cut in tax rates may increase the tax base so much that tax revenues increase.

As the Keynesian perspective triumphed following World War II, most economists believed tax reductions affect output through their impact on total demand. The potential supply-side effects of taxes were ignored. However, in the 1970s, as inflation pushed more and more Americans into high tax brackets, a handful of economists challenged the dominant Keynesian view. Led by Paul Craig Roberts, Norman Ture, and Arthur Laffer, they argued that high taxes were a major drag on the economy and that the top rates could be reduced without a significant loss in revenue. They became known as supply-side economists. During the presidential campaign of 1980, Ronald Reagan argued that high marginal tax rates were hurting economic output, but contrary to what many people think, neither Reagan nor his economic advisers believed that cuts in marginal tax rates would increase tax revenue.

The 1975–1985 period was an era of great debate about the impact of supply-side policies. The supply siders highlighted the positive evidence from two earlier major tax cuts—the Coolidge-Mellon cuts of the 1920s and the Kennedy tax cut of the 1960s. Between 1921 and 1926, three major tax cuts reduced the top marginal rate from 73 percent to 25 percent. The Kennedy tax cut reduced rates across the board, and the top marginal rate was sliced from 91 percent to 70 percent. Both of these tax cuts were followed by strong growth and increasing prosperity. In contrast, the huge Hoover tax increase of 1932—the top rate was increased from 25 percent to 63 percent in one year—helped keep the economy depressed. As the economy grew slowly in the 1970s and the unemployment rate rose, supply-side economists argued that these conditions were the result of high tax rates due to high inflation.

Keynesian economists were not impressed with the supply-side argument. They continued to focus on the demand-side effects, charging that it was irresponsible to cut taxes at a time when inflation was already high. They expected the rate cuts to lead to larger budget deficits, which they did, but also that these deficits would increase demand and push the inflation rate to still higher levels. As Walter Heller, chairman of the Council of Economic Advisers under President John F. Kennedy put it, “The [Reagan] tax cut would simply overwhelm our existing productive capacity with a tidal wave of demand.” But this did not happen. Contrary to the Keynesian view, the inflation rate declined substantially from 9 percent during the five years prior to the tax cut to 3.3 percent during the five years after the cut.

Economists continue to debate the precise effects of the 1980s tax cuts. After extensive analysis of the 1986 rate reductions, both Lawrence Lindsey and Martin Feldstein concluded that for taxpayers previously facing marginal tax rates of 40 percent or more, the drop in tax rates caused such a large increase in taxable income that the government was collecting even more revenue from taxpayers in these top brackets. This would mean that tax rates of 40 percent had had a highly destructive impact on economic activity. Joel Slemrod argued that Lindsey’s and Feldstein’s estimates of the extra income due to tax rate cuts are too high because they inadequately reflect people’s shifting of personal income from high-tax-rate years to low-tax-rate years and of business income from regular corporations to partnerships and Sub-S corporations in response to the lower personal tax rates. According to Slemrod, only a small portion of the increase in the tax base resulted from improvements in efficiency and expansion in the supply of labor and other resources.

Even though economists still disagree about the size and nature of taxpayer response to rate changes, most economists now believe that changes in marginal tax rates exert supply-side effects on the economy. It is also widely believed that high marginal tax rates—say, rates of 40 percent or more—are a drag on an economy. The heated debates are now primarily about the distributional effects. Supply-side critics argue that the tax policy of the 1980s was a bonanza for the rich. It is certainly true that taxable income in the upper tax brackets increased sharply during the 1980s. But the taxes collected in these brackets also rose sharply. Measured in 1982–1984 dollars, the income tax revenue collected from the top 10 percent of earners rose from $150.6 billion in 1981 to $199.8 billion in 1988, an increase of 32.7 percent. The percentage increases in the real tax revenue collected from the top 1 and top 5 percent of taxpayers were even larger. In contrast, the real tax liability of other taxpayers (the bottom 90 percent) declined from $161.8 billion to $149.1 billion, a reduction of 7.8 percent.

Since 1986, the top marginal personal income tax rate has been less than 40 percent, compared with 70 percent prior to 1981. Nonetheless, those with high incomes are now paying more. For example, more than 25 percent of the personal income tax has been collected from the top 0.5 percent of earners in recent years, up from less than 15 percent in the late 1970s. These findings confirm what the supply siders predicted: the lower rates, by increasing the tax base substantially in the upper tax brackets, would increase the share of taxes collected from these taxpayers.

Supply-side economics has exerted a major impact on tax policy throughout the world. During the last two decades of the twentieth century, there was a dramatic move away from high marginal tax rates. In 1980, the top marginal rate on personal income was 60 percent or more in forty-nine countries. By 1990, only twenty countries had such a high top tax rate, and by 2000, only three countries—Cameroon, Belgium, and the Democratic Republic of Congo—had a top rate of 60 percent or more. In 1980, only six countries levied a personal income tax with a top marginal rate of less than 40 percent. By 2000, fifty-six countries had a top marginal income tax rate of less than 40 percent.