What happens to the economy when the government raises or lowers taxes?



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Abstract

Taxation depicts an important picture of every economy. Whenever a government intends to lower or increase its tax rate, it has a huge impact on the economy. Every economy behaves in a different manner when a tax rate is increased or vice versa. This paper will examine that how a minor tax change can impact different variables of an economy like net personal income, gross domestic product, balance of payments, transportation costs, exchange rate etc. Taxes mainly impacts the individuals through changing their spending powers; and businesses through changing their profit margins. How an economy behaves when government raises or lowers the tax rates is the basic question that has been tried to answer in this paper.What happens to the economy when the government raises or lowers taxes?

Introduction

Economy is the backbone of every country and taxation relates to managing this backbone. Whenever there is a change in tax structure or tax policies, an economy is affected either in a favorable manner or vice versa. The most crucial tasks of government include taxation but despite its importance, it has never been popular with the public. Governments usually handle their tax policies as per their requirements because this serves as a basic tool for managing an economy. Increased tax rates are usually linked to control the inflationary patterns whereas reduced tax rates often seen as a useful measure to stimulate economic growth (Peters, n.d.).

Discussion

Net Personal Income and Tax rate

Net personal income usually decreases if the government keeps on increasing the tax rate and the gross income doesn't change which as a result also decreases the person's disposable income. Reduced disposable income means spending less which eventually affects the gross income of those who sell goods or render services. On the macro level, it can result in collecting lesser tax revenues as the increased tax rate can be over-shadowed by population's lowered gross income i.e. 30% of $80,000 is only $24,000 while 25% of $100,00 is $25,000. The decrease in tax rates would have a reverse impact on the economy; improving the net personal income can benefit the economy as savings rate would increase and taxing the population's increased gross income can easily cover the loss caused by lowering the tax rate.

Gross Domestic Product (GDP) and Tax rate

"Tax changes have very large effects: an exogenous tax increase of 1 percent of GDP lowers real GDP by roughly 2 to 3 percent." (Christina Romer, Obama Economic Advisor)

The GDP is comprised of the Consumption, Gross Investment, Government Spending and the Net Exports (which is derived from total exports minus total imports). Mathematically, it can be showed as below.

GDP = C + I + G + (X - M).

The change in the taxes will have a significant impact on the consumption, as the value of the goods and/or services will be impacted. Consumption will be reduced if the taxes are increased which is the result of the decrease ...