CHANGES IN TAXES

The other important instrument of fiscal policy, besides the level of government purchases, is the level of taxation. When the government cuts personal income taxes, for instance, if increases households” take home pay. Households will save some of this additional income, but they will also spend some of it on consumer goods. Because it increases consumer spending, the tax cut shifts the aggregate-demand curve to the right. Similarly, a tax increase depresses consumer spending and shifts the aggregate-demand curve to the left The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. When the government cuts taxes and stimulates-consumer spending, earnings and profits rise, which further stimulates consumer spending. This is the multiplier effect. At the same time, higher income leads to higher money demand, which tends to raise interest rates. Higher interest rates make borrowing more costly, which reduces investment spending. This is the crowding-out effect. Depending on the size of the multiplier and crowding-out effects, the shift in aggregate demand could be larger or smaller than the tax change that causes it. In addition to the multiplier and crowding-out effects, there is another important determinant of the size of the shift in aggregate demand that results from a tax change: households’ perceptions about whether the taxe change IS permanent or temporary. For example, suppose that the government announces a tax  $1,000 per household. In deciding how much of this $1,000 to spend, households must ask themselves how long this extra Income will last. If households expect the tax cut to be permanent, they will view it as adding substantially to their financial resources and, therefore, Increase their spending by a large amount. In this case, the tax cut will have a large impact on aggregate demand. By contrast, if households expect the tax change to be temporary, they will it as adding only slightly to their financial resources and, therefore, will increase their spending on a small. amount. In this case, the tax cut will have a small impact on aggregate demand. An extreme example of a temporary tax cut was the one announced in 1992. In that year, President George H. W. Bush faced a lingering recession and an upcoming reelection campaign. He responded to these circumstances by announcing a reduction in the amount of income tax that the federal government was withholding from workers’ paychecks. Because legislated income tax rates did not change, how ever, every dollar of reduced withholding in 1992 meant an extra dollar of taxes due on April 15, 1993, when income tax returns for 1992 were to be filed. Thus. this “tax cut” actually represented only a short-term . loan from the government. Not surprisingly, the impact of the policy on consumer spending and aggregate demand was relatively small .