Economics: Theory Through Applications

1. Economics: Theory Through Applications

2. This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA

3. Chapter 27Income Taxes

4. 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?

5. 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?

6. Figure 27.1 - Easy Tax Form

7. Figure 27.2- Macroeconomic Effects of Tax Policy

8. Basic Concepts of Taxation

9. Table 27.1 - Revised 2010 Tax Rate Schedules

10. Figure 27.3

11. Marginal and Average Tax Rates

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

13. Figure 27.4 - Real GDP in the 1950s

14. Figure 27.5 - Tax Policy During the Kennedy Administration

15. Consumption Smoothing

16. The Consumption Function

17. Table 27.3 - Consumption, Income and Saving

18. Figure 27.6 - Consumption, Saving and Income

19. The Consumption Function

20. Figure 27.7 - Consumption and Income

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

22. Aggregate Income, Aggregate Consumption, and Aggregate Saving

23. Tax Cuts and National Saving

24. Figure 27.8 - Real GDP in the 1970s

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

26. Labor Supply

27. Figure 27.10 - Labor Supply

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

29. Figure 27.11 - Labor Supply Response to Tax Cut

30. Figure 27.12 - Laffer Curve

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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.