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Tax cuts and the economy during a recession

Paper Type: Free Essay Subject: Economics
Wordcount: 1400 words Published: 1st Jan 2015

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The Economy during a Recession

The effects of the Great Depression revealed the weak areas with in the market system. There was little output from factories and many business’s were failing and shut down. This caused a depletion of available jobs. Around this era, the government played only a small role in the intervention of the downturn. There were few government assistance programs to help the people living in poverty. Many government programs today such as, unemployment compensation, welfare benefits and social security are inspired from the Depression era.

One the government issues a tax cut, it reduces government revenues, which create budget deficits. These tax cuts are a source of government spending that depend on the public needs and priorities.

Our economy went into a recession due to the decline in real GDP. The Obama administration passed legislation in the fall of 2008 to enact an $800 billion fiscal stimulus to be spread out of the course of two and a half years. Many economists believe this policy will not pull our economy out of a recession. Classical Economists believe that unregulated markets are self-stabilizing. They believe government intervention is more harmful than it is beneficial. Classical economists believed that our economy was either at or leading toward full employment. Keynesian economists are more in favor of government intervention to help balance out the market system. They dismiss the idea that the economy is self regulating and will by it self, return to full employment. The Obama administration favors the ideas of John Maynard Keynes.

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Fiscal Policy

The government will use fiscal policy when the economy is not operating at full production and full employment. Fiscal policy helps to stabilize the economy and increase the level of aggregate demand. During the times of a recession, consumers will decrease their spending and increase their saving. Also, unemployment rises causing more and more people to rely on government transfer payments such as unemployment compensation. One way to increase the consumer purchasing power is to lower taxes in order for the private sector to have an increase in money, to be spent on goods and services.

Fiscal policy can level out business cycle fluctuations by expansionary public spending or tax cuts in recessions or contractionary policy in expansions (Weil).

This plan directs government spending and taxes to keep actual GDP close to the potential full employment GDP. The government collects taxes in order to finance expenditures on a number of public goods and services, which can cause a reduction in output.

Discretionary fiscal policy is the purposeful change of expenditures and tax collections by the government to encourage full employment, price stability, and economic growth.

The government uses Expansionary Fiscal policy to shift the AD curve rightward in order to expand real output. The expansionary fiscal policy increases government spending or tax cuts to push the economy out of a recession. It is a increase in government expenditures and or a decrease in taxes that causes the government’s budget deficit to increase or it’s budget surplus to decrease. Usually an expansionary fiscal policy will be needed when the economy is experiencing a recession(McConnell). An increase in unemployment accompanies a negative GDP gap because fewer workers are needed to produce the reduced output. When this happens, the economy is suffering a recession and cyclical unemployment. A sufficient increase in government spending will shift an economy’s aggregate demand curve to the right, ceteris paribus. Investment has a multiplier effect on production. When investment changes, there is an equal primary change in national amount produced. The multiplier represented as 1/(1/MPC) is any change in spending (C, I, or G) will set off a chain reaction leading to a multiplied change in GDP. On the other hand, the government can reduce taxes to shift the aggregate demand curve rightward. According to McConnell and Brue “Suppose the government cuts personal income taxes by $6.67 billion, which increases disposable income by the same amount. Consumption will rise by $5 billion (= MPC of .75 x $6.67 billion), and saving will go up by $1.67 billion (= MPS of .25 x $6.67 billion).”

The AD curve eventually shifts rightward by four times the $5 billion initial increase in consumption produced by the tax cut( McConnell). Real GDP rises by $20 billion, from $490 billion to $510 billion, implying a multiplier of 4. Employment will increase. The multiplier works upward or downward. A tax reduction increases saving, rather than consumption. The smaller the MPC, the greater the tax cut needed to accomplish a specific initial increase in consumption and a specific shift in the Aggregate demand curve. In order to stop the progression of demand-pull inflation, the government will use a contractionary fiscal policy. This policy entails reductions in government spending, tax increases, or a combination of both and will cause the aggregate demand curve to shift to the left. When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus-tax revenues in excess of government spending. A reduction in government spending shifts the AD curve leftward to control demand-pull inflation. The government can use tax increases to reduce consumption spending.

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If the economy has a MPC of .75, the government must raise taxes by $6.67 billion to reduce consumption by $5 billion. The $6.67 billion tax reduces saving by $1.67 billion ( = the MPS of .25 x $6.67 billion). This $1.67 billion reduction is not a reduction in spending.The $6.67 billion tax increase also reduces consumption spending by $5 billion (= the MPC of .75 x $6.67 billion). After the multiplier process is complete, the aggregate demand curve will have shifted leftward by $20 billion at each price level (= multiplier of 4 x $5 billion) and the demand-pull inflation will have been controlled. Leftward shifts of the aggregate demand curve are associated with downshifts of the aggregate expenditures schedule.

Automatic Stabilizers

Automatic stabilizers are programs such as unemployment insurance benefits and taxes that are already on the books to help alleviate recessions and hold down the rate of inflation. Over the course of the business cycle, government tax revenues automatically change in order to stabilize the economy. Transfer payments perform in the opposite way from tax revenues. Unemployment compensation payments, welfare payments, and subsidies to farmers all decrease during economic expansion and increase during economic contraction.

Tax revenues T vary directly with GDP, and government spending G is assumed to be independent of GDP. As GDP falls during a recession, deficits occur automatically and help improve the recession. As GDP rises during expansion, surpluses occur automatically and help counteract possible inflation. There are a number of problems that pertain with applying fiscal policy such as, time lags, political problems, expectations, and state and local finances (Geoff

Riley). One issue in particular is the crowding -out effect which is an increase in government public expenditure that has the effect of. The crowding-out effect increases real national income and output, thus increasing the demand for additional capital. This causes the equilibrium rate of interest to rise and reduces or crowds out the amount of private investment.


The main factors effecting consumer confidence are expectations of future income and employment, current interest rates, trends in unemployment, anticipated changes in government taxation and changes in household wealth. The economy will experience peaks and troughs. Economist’s can look at the history of recessions to evaluate what must be done to help keep the market balanced. The classical economist believed that the market system would be able to fix its self. The Keynesian Economists believe however, the government would need to step in to help boot the current economic downturn. The Obama stimulus package and government tax cuts help to enhance the economy in the long run.


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