what happens to aggregate demand when taxes increase

Discretionary Fiscal Policy Tools

As nosotros begin to look at deliberate government efforts to stabilize the economy through fiscal policy choices, we note that most of the government'south taxing and spending is for purposes other than economical stabilization. For case, the increase in defense spending in the early on 1980s under President Ronald Reagan and in the administration of George W. Bush were undertaken primarily to promote national security. That the increased spending afflicted real GDP and employment was a by-production. The result of such changes on real GDP and the cost level is secondary, but it cannot exist ignored. Our focus here, however, is on discretionary fiscal policy that is undertaken with the intention of stabilizing the economy. Equally nosotros accept seen, the taxation cuts introduced past the Bush-league administration were justified equally expansionary measures.

Discretionary government spending and tax policies can be used to shift aggregate demand. Expansionary fiscal policy might consist of an increase in government purchases or transfer payments, a reduction in taxes, or a combination of these tools to shift the amass demand curve to the right. A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increment in taxes, or a mix of all iii to shift the amass need curve to the left.

Figure 12.8 "Expansionary and Contractionary Fiscal Policies to Shift Amass Need" illustrates the use of fiscal policy to shift aggregate demand in response to a recessionary gap and an inflationary gap. In Panel (a), the economic system produces a real GDP of Y ₁, which is below its potential level of Y _p. An expansionary financial policy seeks to shift amass need to Advertising ₂ in society to close the gap. In Panel (b), the economy initially has an inflationary gap at Y ₁. A contractionary financial policy seeks to reduce aggregate need to Advertizement _ii and close the gap. At present we shall look at how specific fiscal policy options work. In our preliminary assay of the furnishings of financial policy on the economy, we will presume that at a given toll level these policies do not affect interest rates or exchange rates. We will relax that assumption later in the chapter.

Figure 12.viii. Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand. In Panel (a), the economy faces a recessionary gap (YP − Y1). An expansionary fiscal policy seeks to shift aggregate demand to AD2 to shut the gap. In Panel (b), the economic system faces an inflationary gap (Y1 − YP). A contractionary fiscal policy seeks to reduce aggregate demand to AD2 to shut the gap.

Changes in Government Purchases

Ane policy through which the government could seek to shift the aggregate demand curve is a change in government purchases. Nosotros learned that the aggregate demand curve shifts to the right by an amount equal to the initial change in government purchases times the multiplier. This multiplied effect of a change in government purchases occurs because the increase in government purchases increases income, which in turn increases consumption. Then, part of the bear on of the increase in amass demand is absorbed by higher prices, preventing the full increase in existent GDP that would have occurred if the price level did not rising.

Figure 12.9 "An Increase in Regime Purchases" shows the upshot of an increase in government purchases of $200 billion. The initial price level is P ₁ and the initial equilibrium real GDP is $12,000 billion. Suppose the multiplier is 2. The $200 billion increase in government purchases increases the total quantity of goods and services demanded, at a cost level of P _one, by $400 billion (the $200 billion increase in government purchases times the multiplier) to $12,400 billion. The aggregate demand thus shifts to the right by that amount to Advertizing ₂. The equilibrium level of real GDP rises to $12,300 billion, and the price level rises to P ₂.

Figure 12.9. An Increase in Government Purchases. The economic system shown here is initially in equilibrium at a real Gdp of $12,000 billion and a toll level ofP1. An increase of $200 billion in the level of government purchases (ΔG) shifts the aggregate demand bend to the right by $400 billion to AD2. The equilibrium level of real Gdp rises to $12,300 billion, while the price level rises to P2. A reduction in government purchases would have the opposite result. The aggregate demand bend would shift to the left past an amount equal to the initial change in government purchases times the multiplier. Real GDP and the price level would fall.

Changes in Business organization Taxes

One of the showtime financial policy measures undertaken by the Kennedy assistants in the 1960s was an investment tax credit. An investment tax credit allows a firm to reduce its tax liability past a pct of the investment it undertakes during a particular period. With an investment taxation credit of 10%, for example, a house that engaged in $ane million worth of investment during a year could reduce its taxation liability for that year by $100,000. The investment tax credit introduced by the Kennedy administration was subsequently repealed. It was reintroduced during the Reagan assistants in 1981, then abolished past the Tax Reform Act of 1986. President Clinton called for a new investment taxation credit in 1993 as part of his task stimulus proposal, but that proposal was rejected by Congress. The Bush administration reinstated the investment taxation credit as office of its tax cut package.

An investment revenue enhancement credit is intended, of course, to stimulate additional private sector investment. A reduction in the tax rate on corporate profits would exist likely to have a similar effect. Conversely, an increment in the corporate income tax rate or a reduction in an investment revenue enhancement credit could be expected to reduce investment.

A modify in investment affects the aggregate need curve in precisely the same manner as a change in authorities purchases. It shifts the amass need bend by an amount equal to the initial alter in investment times the multiplier.

An increase in the investment revenue enhancement credit, or a reduction in corporate income revenue enhancement rates, will increment investment and shift the aggregate demand curve to the right. Real Gross domestic product and the price level volition rise. A reduction in the investment taxation credit, or an increase in corporate income revenue enhancement rates, volition reduce investment and shift the aggregate demand curve to the left. Existent Gross domestic product and the price level will fall. Investment besides affects the long-run aggregate supply bend, since a alter in the capital stock changes the potential level of real GDP. We examined this earlier in the module on economic growth.

Changes in Income Taxes

Income taxes affect the consumption component of aggregate demand. An increase in income taxes reduces disposable personal income and thus reduces consumption (just by less than the change in disposable personal income). That shifts the amass need curve leftward past an amount equal to the initial change in consumption that the change in income taxes produces times the multiplier. A change in revenue enhancement rates volition modify the value of the multiplier. The reason is explained in another chapter.A reduction in income taxes increases dispensable personal income, increases consumption (but by less than the change in disposable personal income), and increases aggregate need.

Suppose, for case, that income taxes are reduced by $200 billion. Only some of the increase in dispensable personal income will be used for consumption and the rest will be saved. Suppose the initial increase in consumption is $180 billion. So the shift in the aggregate need curve will be a multiple of $180 billion; if the multiplier is 2, aggregate demand will shift to the correct by $360 billion. Thus, as compared to the $200-billion increase in authorities purchases that we saw in Figure 12.9 "An Increase in Regime Purchases," the shift in the amass demand curve due to an income tax cut is somewhat less, equally is the effect on real Gdp and the cost level.

Changes in Transfer Payments

Changes in transfer payments, like changes in income taxes, alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand. A change in transfer payments volition thus shift the aggregate demand bend because information technology volition bear upon consumption. Because consumption will modify by less than the change in disposable personal income, a change in transfer payments of some amount will effect in a smaller change in existent GDP than would a modify in government purchases of the same corporeality. Equally with income taxes, a $200-billion increase in transfer payments will shift the aggregate demand curve to the right by less than the $200-billion increase in government purchases that we saw in Effigy 12.9 "An Increase in Government Purchases."

Table 12.3 "Fiscal Policy in the United States Since 1964" summarizes U.Southward. fiscal policies undertaken to shift aggregate demand since the 1964 tax cuts. Nosotros see that expansionary policies take been chosen in response to recessionary gaps and that contractionary policies accept been chosen in response to inflationary gaps. Changes in government purchases and in taxes have been the primary tools of financial policy in the The states.

Tabular array 12.three Fiscal Policy in the Usa Since 1964

Year	Situation	Policy response
1968	Inflationary gap	A temporary tax increase, starting time recommended by President Johnson's Council of Economical Advisers in 1965, goes into effect. This one-time surcharge of ten% is added to individual income tax liabilities.
1969	Inflationary gap	President Nixon, facing a continued inflationary gap, orders cuts in authorities purchases.
1975	Recessionary gap	President Ford, facing a recession induced by an OPEC oil-price increase, proposes a temporary ten% tax cut. It is passed almost immediately and goes into consequence within two months.
1981	Recessionary gap	President Reagan had campaigned on a platform of increased defence spending and a sharp cut in income taxes. The tax cuts are approved in 1981 and are implemented over a period of three years. The increased defense force spending begins in 1981. While the Reagan assistants rejects the use of financial policy as a stabilization tool, its policies tend to increment amass need early in the 1980s.
1992	Recessionary gap	President Bush had rejected the utilize of expansionary fiscal policy during the recession of 1990–1991. Indeed, he agreed late in 1990 to a cut in government purchases and a tax increase. In a entrada yr, nonetheless, he orders a cut in withholding rates designed to increase disposable personal income in 1992 and to boost consumption.
1993	Recessionary gap	President Clinton calls for a $16-billion jobs bundle consisting of increased government purchases and tax cuts aimed at stimulating investment. The president says the plan will create 500,000 new jobs. The measure is rejected by Congress.
2001	Recessionary gap	President Bush-league campaigned to reduce taxes in order to reduce the size of government and encourage long-term growth. When he took part in 2001, the economy was weak and the $ane.35-billion tax cutting was aimed at both long-term revenue enhancement relief and at stimulating the economy in the short term. It included, for example, a personal income tax rebate of $300 to $600 per household. With unemployment nevertheless loftier a couple of years into the expansion, another tax cut was passed in 2003.
2008	Recessionary gap	Fiscal stimulus package of $150 billion to spur economy. It included $100 billion in tax rebates and $fifty in tax cuts for businesses.
2009	Recessionary gap	Fiscal stimulus package of $787 billion included tax cuts and increased government spending passed in early days of President Obama'south administration.

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