Question

Suppose that the government decides to reduce the lump-sum taxes. Using the diagram, describe and explain the effects of this policy on aggregate output, consumption, employment (or hours worked), and the real wage (note: you should diagram the effects on a graph with the production possibilities frontier and indifference curve).

Answer 1

Lump sum tax is the tax which needs to be paid by taxpayer needs to pay the specific amount irrespective of income i.e. paying same road tax, toll tax etc. When government reduces the lump sum tax everyone purchasing capacity rises. People start spending more on consumption goods which leads to increase in consumption level in the economy. There can be more goods produced in the economy with given resources which leads to PPF moving rightward and overall aggregate output rises.

Initially when there were taxes, the individual chooses point e, where the indifference curve is tangent to the AB budget constraint. When the tax are reduced, the budget constraint moves up to CD, and the individual chooses a point like g, where the new budget constraint is tangent to an indifference curve. The choice can be broken down into two effects. First one is income effect, shown by the movement from point e to point g, and second is substitution effect, the movement from point f to point g.

As working hours increased there is increase in labour supply which reduces the real wage in the market and overall when consumption and aggregate demand rises, employment must have risen in the economy.