Question

The U.S. Senate has passed legislation to extend the Bush-era tax cuts for high-income earners to middleclass Americans earning up to $\mathrm{\$}250,000$ per year. Fact: Middle and low-income earners spend almost all their disposable incomes. High-income earners save a significant part of their disposable incomes. Compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services.

Short answer

An increase in government spending generally has a larger impact on equilibrium real GDP than a tax cut.

Step-by-step solution

- Understand the Problem

You need to compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services. Consider how each policy affects disposable income and spending behavior.

- Decrease in Taxes

A decrease in taxes increases disposable income, especially for middle and low-income earners who spend most of their incomes. This increases consumption, leading to a rise in aggregate demand and hence, equilibrium real GDP.

- Increase in Government Expenditure

An increase in government expenditure directly increases aggregate demand by injecting more money into the economy through spending on goods and services. This also leads to a rise in equilibrium real GDP.

- Compare the Marginal Propensity to Consume (MPC)

Since middle and low-income earners spend almost all their disposable incomes, their Marginal Propensity to Consume (MPC) is high. High-income earners have a lower MPC as they save a significant portion of their income. Hence, a tax cut for middle-income earners leads to a larger increase in aggregate consumption than for high-income earners.

- Analyze Multiplier Effect

The government spending multiplier may be larger than the tax multiplier because every dollar of government spending directly increases aggregate demand. Due to high MPC among middle-income earners, the effect of a tax decrease could be significant, though slightly less impactful than direct government expenditure.

- Conclusion

Both policies will increase equilibrium real GDP. However, the increase in government spending typically has a larger and more direct impact compared to a tax cut, particularly when high MPC is considered.

Key concepts

Equilibrium Real GDP

Equilibrium real GDP is the point where total output produced equals total spending in the economy. This means the supply of goods and services is exactly matched by demand. When we talk about fiscal policies such as tax cuts or increased government spending, we're interested in how these actions shift aggregate demand to move the economy towards or away from this equilibrium.

A higher equilibrium real GDP implies more economic activity and generally more employment. Conversely, a lower equilibrium indicates less economic activity. To understand fiscal policies' impact, we need to grasp how these policies change spending behaviors and demand within the economy.

Tax Cuts

Tax cuts are aimed at increasing disposable income, especially for middle and low-income earners. When people have more disposable income, they are likely to increase their consumption. This increase in consumption boosts aggregate demand.

Especially when tax cuts target middle-class households, who tend to spend a greater proportion of their income, the effect on equilibrium real GDP can be substantial. These households usually spend almost all of their additional income, leading to a higher marginal propensity to consume (MPC). However, this effect can vary depending on which income groups are targeted by the tax cuts.

Government Spending

Government spending directly injects money into the economy by purchasing goods and services or funding projects. This kind of fiscal policy action increases aggregate demand almost immediately.

The impact of government spending is usually seen through the government spending multiplier. For every dollar the government spends, there's a multiplied increase in economic activity as money cycles through the economy. This can lead to a more significant boost in equilibrium real GDP compared to tax cuts, especially since it does not rely on individual spending decisions.

For example, if the government builds a new highway, it not only creates jobs but also enhances future economic productivity by improving infrastructure.

Marginal Propensity to Consume (MPC)

The Marginal Propensity to Consume (MPC) measures the portion of additional income that consumers spend on goods and services as opposed to saving. For instance, an MPC of 0.8 means that for every additional dollar received, 80 cents will be spent.

Middle and low-income earners typically have a high MPC because they spend most of their disposable income on essential goods and services. High-income earners, however, have a lower MPC as they save a considerable portion of their additional income.

Understanding MPC is crucial in determining the effectiveness of fiscal policies. A tax cut for lower-income groups will generally result in a higher increase in consumption and thus aggregate demand, compared to tax cuts for higher-income individuals.

Aggregate Demand

Aggregate demand is the total demand for goods and services in an economy at a given overall price level and in a given period. It is composed of consumer spending, investment, government spending, and net exports. Aggregate demand is crucial for determining the overall economic activity.

When the government implements tax cuts or increases government spending, it tries to shift aggregate demand to close any output gaps. A higher aggregate demand typically leads to a higher equilibrium real GDP, which means greater economic activity and employment.

By analyzing how fiscal policies influence aggregate demand, one can gauge their effectiveness in moving the economy toward higher equilibrium real GDP.