Question

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

Short answer

People will just keep one‘s requirement low if they know the tax cut is only temporary because they'll have to pay more in the future.

Step-by-step solution

Concept introduction.

A temporary tax reduction will only last a year or two before returning to its previous level. A permanent modification, on the other hand, will last indefinitely. Both temporary and permanent measures affect aggregate demand in different ways.

Explanation of solution.

A permanent tax change will elicit a stronger reaction from the public than just a transitory tax change in the rate. When the government implements a tax decrease, people's income generally rises, allowing them to consume more. However, if people are aware that the tax break is just transitory, many will choose to keep their money rather than spend it, knowing that they'll have to pay taxes again in the future. People do tend to spend less as a result of their savings, and aggregate demand will remain unchanged.