Question

On average, does an increase in taxes raise or lower real GDP? If taxes as a percentage of GDP go up by 1 percent, by how much does real GDP typically change? Are the decreases in real GDP caused by tax increases temporary or permanent? Does the intention of a tax increase matter?

Short answer

An increase in taxes lowers real GDP, on average.

If the taxes increase by 1%, then real GDP falls by 2 or 3%.

The decrease in real GDP due to taxation is temporary.

Yes, the intention of tax matters as different tax policies affects real output change.

Step-by-step solution

The relation between real GDP and tax rate 

It has been observed from empirical studies that a negative relationship exists between tax rate and real GDP. Therefore, on average, as the tax rate rises, real GDP falls. In fact, during high economic growth, real GDP rises only if income increases.

Effect of 1 percent rise in tax on GDP

The empirical tests show that a percent rise in tax rates reduces real GDP by a higher percentage. So, if the taxes rise by 1%, real GDP falls by 2% or 3%.

The effect of tax increase on the economy 

The decrease in real GDP caused by an increase in taxation is not permanent but temporary. The increase in tax rates causes aggregate demand to fall, which generates real GDP to drop. However, the economy adjusts via a change in people's expectations, interest rates, and input prices in the long run. Thus, the output reverts to the potential level in the long run

Importance of intention of tax

Yes, the intention of tax matters. The reason is that different tax policies have different effects on economic growth. For instance, the taxes aimed to pay for government expenses or counteract other influences on the economy are less likely to influence real GDP. The tax rates correlate with other factors that affect the economy and have unreliable effects on GDP.

Conversely, the tax policies aimed to promote long-term growth or reduce the inherited budget deficit have considerable effects on output level. Both investment and consumption decrease due to an increase in the tax rate, leading to a large fall in real GDP. Therefore, the intention of tax increase matters.