Question

Suppose the amount the federal government collects in personal income taxes increases, while the level of GDP remains the same. What will happen to the values of national income, personal income, and disposable personal income?

Short answer

An increase in personal income tax collections will decrease disposable personal income while keeping national income and personal income unchanged, given that GDP remains the same.

Step-by-step solution

Understand the Concepts

National income is the total income of a nation's residents, while personal income refers to individuals' earnings. Disposable personal income is personal income minus personal tax and non-tax payments, representative of the income available to individuals for personal consumption, saving, and investing. Gross Domestic Product (GDP) represents the total value of all goods and services produced within a country in a given period, which incorporates national income.

Consider the Effects of Increased Personal Income Taxes

When the federal government collects more in personal income taxes, it implies that individuals' disposable personal income will decrease because they are paying more taxes. However, the level of personal income remains unaffected; only the portion taken as tax, altering disposable income, changes. National income and GDP also remain unchanged as they are not influenced directly by variations in personal tax rates.

Summarize the Impacts

An increase in personal income tax collections by the federal government, while the level of GDP remains constant, will lead to a decrease in disposable personal income, as more money from their earnings is going towards tax payments. However, this won't affect the values of national income and personal income, these figures will remain constant as the overall income doesn't change, only the distribution does.

Key concepts

National Income

National income is a broad concept that encompasses the total income earned by a nation’s residents. This includes salaries, rents, profits, and interest, which are all generated within the economy. Essentially, national income reflects the wealth produced by the country during a specific period. It is crucial for evaluating the economic performance and wellbeing of a nation. When considering how national income relates to Gross Domestic Product (GDP), it's essential to note that GDP measures the total economic output, while national income is concerned with the income earned from this output. Since GDP remains constant in our exercise, national income does as well, regardless of changes in individual tax policies.

Key elements contributing to national income include:

• Compensation of employees: wages and salaries received by workers
• Corporate profits: earnings from corporations after expenses
• Rental income: income earned from property ownership
• Interest income: money made from lending

Understanding national income helps us analyze the economic strength and fiscal capacity of a country.

Personal Income

Personal income is a measure that reflects the earnings of individuals within the economy. It includes wages, salaries, dividends, rent, and any other income received by an individual. Personal income is a crucial indicator because it gives insight into the financial health of the population.

The exercise highlights a situation where personal income remains unchanged despite increased tax collections. This is because personal income represents the total earnings before taxes are applied. Even if more taxes are collected, the actual amount earned by individuals before tax deductions does not fluctuate.

Components of personal income include:

• Labor income: received from employment
• Investment income: dividends and interest
• Transfer payments: social security, unemployment benefits

Despite its apparent stability, changes in personal income tax rates primarily influence disposable personal income rather than personal income itself.

Disposable Personal Income

Disposable personal income is perhaps the most direct measure of an individual's economic situation. It is the income left over after personal taxes and other mandatory payments have been subtracted from personal income. This is the money available for personal consumption, savings, and investments, which makes it a critical figure when analyzing consumer behavior and economic activity.

Increased personal income taxes directly reduce disposable personal income. Even though personal and national incomes remain unchanged, the increase in taxes reduces the amount people can spend or save. As a result, disposable personal income is a more volatile measure sensitive to policy changes.

This emphasizes the significance of understanding how income distributions and fiscal policies can impact:

• Consumer spending: as disposable income drops, spending may decrease
• Saving rates: individuals may save less with less disposable income
• Economic investment: less personal savings can result in fewer investments

Ultimately, disposable personal income plays a pivotal role in both individual financial planning and broader economic analysis.