Dear Economic Advisor: I am considering a stimulus package to reduce the negativ

Question

Dear Economic Advisor:
I am considering a stimulus package to reduce the negative effect of the recession. The stimulus package will cut taxes by 20 per cent. Before deciding whether to pursue this type of policy, I would like your analysis. I see little hope of reducing government spending, so the tax cut would mean an increase in the budget deficit. How would the tax cut and budget deficit affect the economy and the economic well-being of the country?

Analysis the long-run effects, short-run effects, and how it affects international trade.

Explanation / Answer

i will like to go in favour of your statement . Taxes enter many decisions, but the two most important are probably that they discourage work, since they lower the aftertax return from work, and they discourage saving and investment, since they lower aftertax returns. (A third, which we will not explore here, is that taxes distort investment decisions by taxing different types of capital unequally. Housing, for example, gets a free ride.) We know that the countries that invest the most (measured as the ratio I/Y) also grow the fastest, on average, so maybe this is important (or maybe the causality goes the other way, with the US investing less because it has fewer good opportunities). Whatever the case, let's examine the effect of taxes on wage and capital income. A lower tax rate on wage income should increase the labor supply. Given the labor demand function, this increase in labor supply will increase employment, reduce the pre-tax real wage and increase the post-tax real wage. Now turn to saving. We would expect lower taxes on interest and capital gains, as well as tax-sheltered saving plans like IRAs and 401(k) plans, to make saving more attractive and lead to an increase in savings. In equilibrium, this will lower real rates of interest as more saving flows into capital markets, and raise investment. Over time this investment leads to higher capital, more productive labor, and higher output and wages. (This is the long-run dynamics effects of this policy change). The effect on saving, though, is thought by some to be substantial but there is wide disagreement on this issue as well. There is some question how responsive saving is to tax incentives, but a number of economists, including Martin Feldstein of Harvard, think the effect is important. Some argue that the saving rate in the US is smaller than in most other major economies, perhaps because US tax law is less friendly to saving than other countries'. One of the important policy questions is whether we should amend the tax system to make saving more attractive.

Related Questions

Navigate

• Browse (All)
• Browse D
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.