PLEASE HELP!!! THIS IS PART OF MY TAKE HOME FINAL EXAM! A principal point of con

Question

PLEASE HELP!!! THIS IS PART OF MY TAKE HOME FINAL EXAM!

A principal point of contention between keynesian and supply-side proponents concerns the proper function of tax reductions.According to the keynesians, tax-cut money should be used by consumers to purchase goods and services-thereby stimulating output,employment, and incomes. supply-siders, on the other hand, belive that tax-cut dollars should go into savings,which would be available for real investment-thereby reducing costs, increasing output, creating jobs, and increasing incomes.

Explanation / Answer

Answer:

a) When tax is cut and government expenditure is increased to increase the total disposable income of consumers in a country, it is called expansionary fiscal policy. In this application expansionary fiscal policy measure is taken to improve the employment, output of the country.

b) Yes, multiplier effect works on tax cut dollars as well as on government expenditure dollars. If tax is decreased by the government by t amount then at that period consumption will increased by bt amount. So income/output is increased by bt amount in that period. At the next period, consumption will increase by b(bt) amount for increase in income in the previous period and this will has direct effect on income by the same amount. This process will continue at infinite time period.

So, y = bt + b2t + b3t + ........

or, y = bt(1 + b + b2 + . . . . .)

or, y = bt[1/(1-b)]

this is called tax multiplier.

The same thing happen in case of government expenditure. When government expenditure increases by g amount, it increase the y by the amount of g amount at that period. So at the next period consumption will increase at bg amount and increases the income by the same amount bg. At the next period this increased income increases the consumption by b(bg) amount and income also increases by direct effect by b(bg) amount. This process will continue.

y = g + bg + b2g + . . . . .

or, y = g(1 + b + b2 + . . . . .)

or, y = g [1/(1-b)]

c) Tax cut in 1980s was initiated to increase the total income of the country that can generate the aggregate demand more power full and increase the employment level. the situation at that time was quite different as the total savings did not increase. People above income level $50,000 had more propensities to save their tax cut incomes than people below $50,000 income. So total savings did not increase at the end of the day and so investment could not be increased. The main goal of this tax cut was to increase the savings and not to fund more government spending by increasing government expenditure. This tax cut had little impact on economic growth but had increased the inequality in the economy. As the tax cut was oriented towards the tax reduction only for business and high income tax payers those have larger propensity to save. Tax bracket creep and social security taxes that were resulting from high inflation at that time crunched all the tax cut incomes of below $50,000 income earners.

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