Question

What is a potential problem with a temporary tax increase designed to increase aggregate demand if people know that it is temporary?

Short answer

The potential problem with a temporary tax increase designed to increase aggregate demand, if people know it is temporary, is that it might not effectively stimulate the economy. People may choose to save more or postpone their spending, and businesses might delay investments, waiting for the lower tax rates to return. This could result in a decrease, instead of an increase, in aggregate demand, leading to a failure in achieving the intended economic stimulus.

Step-by-step solution

Understanding the objective of a temporary tax increase

A temporary tax increase is designed to increase aggregate demand. The rationale behind this is to stimulate economic activity, which might be desired during an economic downturn or in a period of recession. The government may do this by increasing taxes temporarily, expecting people to spend more and businesses to invest more, thus boosting aggregate demand in the short term.

Considering how people might respond if they know the tax increase is temporary

If people know that the tax increase is temporary, they might change their behavior accordingly. Instead of spending and consuming more, they might choose to save more or postpone their spending until after the tax increase has ended. Similarly, businesses might put off investments until the tax rate returns to its lower level.

Identifying the potential problem with a temporary tax increase

The potential problem with a temporary tax increase designed to increase aggregate demand, if people know it is temporary, is that it might not have the intended effect of stimulating the economy. People might choose to save more or postpone their spending and businesses might delay investments, waiting for the lower tax rates to return. This could result in a decrease, rather than an increase, in aggregate demand, leading to a failure in achieving the intended economic stimulus.