Briefly explain the effects on potential GDP of cutting each of the following taxes: a. Individual income tax b. Corporate income tax c. Taxes on dividends and capital gains

Question

What will be an ideal response?

Answer 1

a. Reducing the marginal tax rate on individual income will reduce the tax wedge faced by workers, thereby increase the quantity of labor supplied. This will increase potential GDP. Most households are also taxed on their returns from saving at the individual tax rates, so reducing marginal tax rates increases the return to savings. This will increase investment, and as the economy accumulates more capital goods, potential GDP will increase.
b. Cutting the corporate tax rate will encourage investment spending and can also increase the pace of technological change. This leads to more capital goods and improved technology, so the overall level of economic efficiency will increase, which increases potential GDP.
c. Lowering the tax rate on dividends and capital gains increases the supply of loanable funds, increasing saving and investment, and lowering the equilibrium real interest rate. This leads to a larger capital stock and increases potential GDP.