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12.5 End-of-Chapter Material

In Conclusion

Our goal in this chapter was to understand the effects of tax changes on aggregate consumption and aggregate output. A tax cut puts more income in the hands of households, and thus consumption increases. The increase in consumption in turn leads to an expansion in the overall level of economic activity. The framework does a good job of describing and explaining actual economic outcomes during the Kennedy tax cut. We can thus have some faith that our basic framework is reasonably sound. Having said that, it is a very simple model that does have some deficiencies, most notably its neglect of the supply side of the economy.

Income tax cuts also decrease overall national saving. Income tax cuts increase household disposable income and lead to increased saving by households (as well as increased consumption). At the same time, however, income tax cuts mean that the government is saving less (or borrowing more). The net effect is to decrease national saving. The theory of economic growth tells us that reduced saving has the effect of decreasing future standards of living.

We then examined the Reagan tax cuts of the 1980s. These tax cuts were aimed at stimulating employment and output by encouraging people to work more. The belief that tax cuts lead to an increase in the quantity of labor supplied is consistent with basic microeconomic principles, but there is disagreement about the likely size of the effect.

Although we cast our discussion of the effects of taxes on spending using the tax cuts of the Kennedy and Reagan administrations, the lesson is more general. It is common for the United States and other countries to use variations in income tax rates as a tool of intervention. We highlighted several effects of such interventions. Income tax changes alter the level of household disposable income and thus influence consumption expenditures; they affect saving and capital accumulation; and they affect labor supply. This policy tool therefore gives the government considerable influence on the aggregate economy.

Indeed, when the crisis of 2008 hit the world’s economies, many countries responded by implementing expansionary fiscal policies, including cuts in taxes. Australia, the United Kingdom, Singapore, Austria, and Brazil are just a few of the countries who cut taxes in response to the crisis.

We used the Kennedy tax cut to illustrate demand-side effects and the Reagan tax cut to illustrate supply-side effects because those were the channels emphasized by the economic advisors at the time. Just about every change in the income tax code, however, has effects on consumption, saving, and labor supply. Every change in the code has short-run effects and long-run effects, and, as we have seen, these effects can be contradictory. Thus whenever you hear or read about proposed changes in taxes, you should try to remember that all these different stories will be in operation. The politicians and pundits who are supporting or opposing the change will typically talk about only one of them, depending on the spin they wish to convey. The analysis of this chapter should help you always see the bigger picture.

Finally, remember that tax changes will typically have major effects on the distribution of income. There are winners and losers from every change in the tax code. This, above all, is why changes in the tax code are an endless source of political debate.

Key Links

Exercises

  1. Suppose that your income level is $55,000. Using the tax table for 2010 (Table 12.1 "Revised 2010 Tax Rate Schedules"), what are your marginal and average tax rates?
  2. Suppose that taxes paid were equal to a constant plus a tax rate times income. Devise a tax schedule such that the marginal tax rate is 25 percent and the average tax at $10,000 is $2,000. What is the constant?
  3. In times of inflation, the nominal income of households increases. What happens over time to their marginal and average tax rates?
  4. Our tax function has a constant marginal tax rate at all levels of income. Explain why this means that the average tax rate is also constant. Is the average tax rate higher, lower, or equal to the marginal tax rate in this case?
  5. We noted earlier that the average tax rate for someone earning $100,000 was 67 percent in 1963. However, there has been considerable inflation between 1963 and the present day. What is the equivalent in current dollars of an income of $100,000 in 1963? (Look at the toolkit if you need a reminder of how to convert from nominal to real variables.)
  6. Suppose that autonomous consumption is 600 and the marginal propensity to consume is 0.9. Graph the consumption and savings functions first with disposable personal income on the horizontal axis and then with GDP on the axis. If there is a change in taxes, how would that affect these graphs?
  7. What is the difference between the marginal propensity to consume and the marginal propensity to spend?
  8. Why is a temporary tax cut likely to have a smaller impact on real GDP than a permanent tax cut?
  9. Using the logic of consumption smoothing, if a tax cut from 10 years ago will expire next year, what will a household do now in anticipation of the coming tax change?
  10. If labor supply is known to be relatively insensitive to changes in the real wage, what does this imply about the argument that cuts in tax rates can lead to revenue increases?

Economics Detective

  1. Pick some country other than the United States. Can you find the income tax rates for that country? How do they compare with those in the United States?
  2. Go to the IRS web page. Suppose that you are a member of a married household with total household income of $55,000. What are your marginal and average tax rates? Compare these to the tax rates on individuals. Which group faces the higher marginal income tax rate? What effects might this have on their behavior?
  3. In the summer of 2010, the George W. Bush tax cuts were about to expire. What would the change in tax rates be if the tax cuts had been allowed to expire?
  4. Go to the Bureau of Economic Analysis website (http://www.bea.gov). Click on the link “Personal Income and Outlays” and find out what has happened recently to personal income and disposable income. Have they been increasing or decreasing?

Spreadsheet Exercises

  1. Using a spreadsheet, enter the data for disposable income and consumption from Table 12.4 "Consumption and Income in the 1960s (Seasonally Adjusted, Annual Rates)". Now enter a formula to calculate the average propensity to consume and another to calculate the marginal propensity to consume. Check that your answers are the same as in Table 12.4 "Consumption and Income in the 1960s (Seasonally Adjusted, Annual Rates)".
  2. Suppose autonomous consumption is 6000 and the marginal propensity to consume is 0.9. Furthermore, suppose the tax rate is 30 percent. Create a spreadsheet where the first column is income, ranging from $0 to $100,000, by increments of $1,000. Create columns showing the taxes paid at each income level, the level of disposable income at each income level, and consumption at each income level. Graph the relationship between consumption and income. What is the slope of the line? Experiment with changing the marginal propensity to consume and the tax rate. Explain how changing these parameters affect the relationship between consumption and income.