Reduce the Tax on Households

The immediate impact of the tax cut is to raise disposable income and thus to raise consumption. Disposable income rises by ΔT, and consumption rises by an amount equal to ΔT times the marginal propensity to consume MPC. The higher the MPC, the greater the impact of the tax cut on consumption.

Because the economy’s output is fixed by the factors of production and the level of government purchases is fixed by the government, the increase in consumption must be met by a decrease in investment. For investment to fall, the interest rate must rise. Hence, a reduction in taxes, like an increase in government purchases, crowds out investment and raises the interest rate.

Because the tax cut raises disposable income byΔT, consumption goes up amounts as consumption rises.

Figure 1    Decrease in savings rate moves the steady state

According to neoclassical growth theory, the savings rate does not affect the growth rate in the long run.

In Figure 1 we show how a decrease in the savings rate affects growth. In the short run, a decrease in the savings rate reduces the growth rate of output. It does not affect the long-run growth rate of output, but it reduces the long-run level of capital and output per head.

References

The Open University of Hong Kong (1998) 'National income and growth' in EC301 Economic Analysis of Business and Public Policies, Hong Kong: OUHK.

Mankiw, N G (1997) Macroeconomics, New York: Worth.

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