2. TAX POLICY;
1# DEMAND SIDE EFFECT
A) Tax Cut:
Let Govt reduces taxes, the disposable income of peoples
will increased, as a result consumption will increase
Let govt replaces its revenue lost by selling bonds to the
public.
Demand for loanable funds will increase.
Interest rate will increase.
Saving will increase, resulting crowding out effect.
3. Cont….
b) Printing new Money;
Let Govt replaces its revenue lost by printing new
money, this will increase money supply.
The increase money supply will increase prices.
Increase prices will increase aggregate demand.
4. Supply Side Effects
Tax Cut:
Let govt reduces marginal income tax rate1 .
Let the initial marginal income tax rate is 40% and Govt
reduces to 20%2 .
Now every individual out of his income is paying less, in
other words real income of individual increased.
As we know that Ns = g (w/p).
After tax deduction aggregate labor supply curve would be
come
1 Marginal income tax rate is percentage of tax which person gives on his her income. i.e. T = To+ tY, where t is the
marginal income tax.
2 T=To+0.4Y reduces to T=To+0.2Y
5. Conti….
Here aggregate labor supply is function of real
wage(W/P), real wage increase will lead to
increase ALS and vice versa.
Let Ns= (1-tY)(W/p).
Here ASL is function of tax rate and real wages.
Tax rate will affect aggregate supply of labor.
Lets explain it with following diagram.
6. Supply Side Effects
Of Income Tax Cut
a)Labor market equilibrium with
changes in marginal income tax
b)Production function
c) Aggregate demand and supply
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
output
Agreggatepriceleveloutput
Yo
Y1
No N1
Yo Y1
Y = F (K, N)
Po
P1
A
B
A B
Yd
ASo
AS1
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
Agreggatepriceleveloutput
Yo
Y1
No N1
Y = F (K, N)
Po
P1
A
B
A B
Yd
ASo
AS1
7. The first diagram represents equilibrium
In labor market, where basic equi: take place
At point A, where Ns = Nd. W/P is real wage rate
And No is the level of Employment.
The second diagram represents the level
of total output produce in economy, here with
The level of employment No total output
Produce is Yo.
Third diagram depicts equilibrium level
of output and prices, Po is equilibrium price
And Yo, equilibrium quantity, determined by
By the market forces(AD an AS).
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
output
Agreggatepriceleveloutput
Yo
Y1
No N1
Yo
Po
P1
A
B
A B
Yd
ASo
AS1
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
Agreggatepriceleveloutput
Yo
Y1
No N1
Po
P1
A
B
A B
Yd
ASo
AS1
Y1
8. Let govt reduces marginal income tax
rate to 20% (t = 0.2). As a result of such
deccrease real wages of labor increases,
this will induce labor to work more, as result ASL
will shift to the right, as shown in figure a
New eauilibruim will take place in labor
market at point B,where N1 is equ level of
Employenet and( W/P)1 is real wage rate.
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
Agreggatepriceleveloutput
Yo
Y1
No N1
Y = F (K, N)
Po
P1
A
B
A B
Yd
ASo
AS1
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
Agreggatepriceleveloutput
Yo
Y1
No N1
Y = F (K, N)
Po
P1
A
B
A B
Yd
ASo
AS1
9. As result of such increase in employment
Output will increase to Y1.
This will shift the As supply to As1, as result
Of increase in AS prices will decrease to
P1.
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
Agreggatepriceleveloutput
Yo
Y1
No N1
Y = F (K, N)
Po
P1
A
B
A B
Yd
ASo
AS1
MPN= Nd
Ns (tY = 0.40)
Ns (tY + 0.20)
b
(W/P)0
(W/P)1
No N1
Realwages
Employment
Employment
Agreggatepriceleveloutput
Yo
Y1
No N1
Y = F (K, N)
Po
P1
A
B
A B
Yd
ASo
AS1
Yo
Editor's Notes
Marginal income tax rate is percentage of tax which person gives on her income. i.e. T = To+ tY, where t is the marginal income tax
