Tax Cut Questions?

Question

1) One cornerstone of President George W. Bush's economic policy during his first term in office was tax cuts targeted towards high income and high net worth households. Under his proposals the marginal tax rate applied to capital gains taxes has been reduced, taxes on stock dividend have been eliminated and marginal tax rates on wage and interest income, particularly those applied to high income brackets have also been reduced.

a) What would be the short-run effects of tax cuts on interest rates and growth in RGDP given that the economy was in recession at the time of Bush’s tax cuts? Contrast the Keynesian and crowding out perspectives on this question.

b) If in question (a) we were interested in the long run effects of the proposed tax cuts would a "supply side" economist give a different answer to this question than an economist who believed that federal budget deficits created significant "crowding out" effects? Explain.

Answer 1

The implicit assumption in this question is that a tax cut would imply increased deficit financing by the Govt. This is not necessary. A tax cut could have been associated with equivalent cut in Govt. expenditure. In the Keynesian format such balanced budget tax cut would not have a strong multiplier effect on RGDP to pull the economy out of recession.  However, from a supply side economist's point of view, it is higher savings and investment leading to additional capacity that helps faster growth in RGDP if the economy suffers from capacity bolltlenecks to growth. Now the specific questions:

(a). Tjhe short run effect would be both an increase in savings and consumption. From a Kenesian standpoint, the mutiplier effect on GDP would be considerable givwen the high marginal propensity to consume but not as much RGDP expansion would occur had Godt spending been increased by an equivalent amount than the tax. But in this case there would not be much crowding out effect because of the increased Govt. deficit and borrowing as the savings would have also increased.

(b) From a long-run perspective, lower marginal tax rates would increase both savings of higher income bracket families and increase the profit after tax of the companies. This would have encouraged investment in capacity that would increase the potential GDP and enable higher RGDP growth with least effect on creating inflationary pressures. The longrun crowding out effect is unlikely to be great as the spurt in investment and the operation of the multipler would lead to faster growth in RGDP and hence higher revenue calculations resulting in reducing the budget deficit and hence arrest the growth of govt. borrowing in the market. All this however is a general answer: much would depend on the quantitative relationships linkin mpc to tax multiplier, the tax bouyancy as RGDP increases, the capital-output ratio, etc.