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Economics: Theory Through Applications

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Chapter 27Income Taxes

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Learning Objectives

• What is the difference between a marginal and an average tax rate?

• How does the tax system redistribute income?

• What was the state of the economy prior to the Kennedy Tax Cut of 1964?

• What framework did the economists at that time use to predict the effects of this tax cut?

• What was the response of the economy to this tax cut?

• When income taxes are cut, what happens to private saving?

• When income taxes are cut, what happens to national saving?

Learning Objectives

• What was the state of the economy at the time of the Reagan tax cut?

• What framework was used for analyzing the effects of this tax cut?

• What were the effects of the tax cut?

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Figure 27.1 - Easy Tax Form

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Figure 27.2- Macroeconomic Effects of Tax Policy

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Basic Concepts of Taxation

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taxable income adjusted gross income deduction exemption

taxable income adjusted gross income deductions and exemptions

Table 27.1 - Revised 2010 Tax Rate Schedules

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Figure 27.3

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Marginal and Average Tax Rates

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taxes paid tax rate income

Table 27.2 - The Redistributive Effects of Taxation (in US$)

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Figure 27.4 - Real GDP in the 1950s

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Figure 27.5 - Tax Policy During the Kennedy Administration

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Consumption Smoothing

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disposable income consumption saving

The Consumption Function

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consumption autonomous consumption marginal propensity to consume disposable income

Table 27.3 - Consumption, Income and Saving

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Figure 27.6 - Consumption, Saving and Income

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The Consumption Function

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consumptionaverage propensity to consume

disposable income

savingssavings rate

disposable income

Figure 27.7 - Consumption and Income

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Table 27.4 - Consumption and Income in the 1960s (Seasonally Adjusted, Annual Rates)

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Aggregate Income, Aggregate Consumption, and Aggregate Saving

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real GDP multiplier autonomous spending

change in real GDP multiplier change in autonomous spending

change in real GDP multiplier change in autonomous spending

Tax Cuts and National Saving

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national saving private government deficit

national saving private saving government surplus

Figure 27.8 - Real GDP in the 1970s

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Figure 27.9 - Marginal and Average Tax Rates, 1982 to 1984

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Labor Supply

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leisure hours working hours 24 hours

leisure hours nominal wage nominal wage income 24 nominal wage

leisure hours nominal wage price level consumption 24 nominal wage

leisure hours

real wage consumption 24 real wage

Figure 27.10 - Labor Supply

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The Effect of the Reagan Tax Cuts on the Supply of Labor

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nominal wagedisposable income hours worked (1 tax rate)

price level

hours worked (1 tax rate) real wage

Figure 27.11 - Labor Supply Response to Tax Cut

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Figure 27.12 - Laffer Curve

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Key Terms

• Marginal tax rate: The marginal tax rate is the tax rate paid on additional income

• Average tax rate: The average tax rate is the ratio of total taxes paid to income.

• Disposable income: Disposable income is equal to household income less taxes paid

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Key Terms

• Circular flow of income: The circular flow of income measures the money flows among the different sectors of the economy as individuals and firms buy and sell goods and services

• Multiplier: The multiplier equals one divided by one minus the marginal propensity to spend and is key to understanding how a change in autonomous spending effects output in the aggregate expenditures model

• Aggregate expenditure model: The aggregate expenditure framework studies the relationship between planned spending and output

• Personal income: Personal income is the income in the economy that flows to households

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Key Terms

• Disposable income: Disposable income is equal to income minus taxes paid to the government

• Consumption smoothing: Consumption smoothing is the idea that households like to keep their flow of consumption relatively steady over time, smoothing over income changes

• Consumption function: The consumption function is a relationship between current disposable income and current consumption

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Key Terms

• Marginal propensity to consume: The marginal propensity to consume is the amount consumption increases when disposable income increases by a dollar

• Marginal propensity to save: The marginal propensity to consume is the amount saving increases when disposable income increases by a dollar

• Average propensity to consume: The average propensity to consume is the ratio of consumption to disposable income

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Key Terms

• Savings rate: The savings rate is the ratio of household saving to disposable income

• Exogenous variable: An exogenous variable is determined outside the model and is not explained in the analysis

• Potential output: Potential output is the amount of real GDP the economy produces when the labor market is in equilibrium and capital goods are not lying idle

• Income effect: As income increases, households choose to consume more of everthing, including leisure

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Key Terms

• Substitution effect: As the real wage increases, household substitute away from leisure towards consumption of goods and service and thus supply more labor

• Time budget constraint: According to the time budget constraint, the sum of hours worked each day plus leisure time each day equals 24 hours

• Real wage: The real wage is the nominal wage corrected for inflation

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Key Takeaways

• The marginal tax rate is the rate paid on an additional dollar of income while the average tax rate is the ratio of taxes paid to income

• When the marginal tax rate is increasing in income, then the tax system redistributes from rich to poor households. In this case, after tax income is more equal than income before taxes are paid

• Beginning in the early 1960s, growth of real GDP began to slow

– This provided the basis for the tax cut of 1964

• The economists at the Council of Economic Advisors used the aggregate expenditures model as the basis for their anlaysis of the effets of the tax cut 27-37

Key Takeaways

• In response to the tax cut, consumption and real GDP both increased. This fits with the prediction of the aggregate expenditure model

• Since the marginal propensity to consume is less than one, a tax cut will lead to a household to consume more and save more

• National saving, the sum of public and private saving, will generally fall when there is a tax cut

• Prior to the Reagan tax cut, the U.S. economy was experiencing both low growth in real GDP and high inflation

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Key Takeaways

• Reagan’s economic advisors stressed the effects of taxes on the supply side of the economy, principally the incentive effects of taxes on labor supply and investment

• The Reagan tax cuts lead to considerably higher deficits in the U.S.

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