The government of Techland is planning a cut in income tax rates. What is the possible consequence of such a change in policy on Techland's economy if it is implemented?

Question

What will be an ideal response?

Answer 1

A cut in income tax rates in Techland will increase the disposable income of consumers. This is likely to lead to an increase in consumption. The rise in consumption might have multiplier effects, causing a domino effect of rising consumption, rising firm revenues, rising firm hiring, rising household income, and yet more consumption. In addition, a cut in the income tax might lead workers to supply more labor because their after-tax wages will have risen though this effect is estimated to be small in magnitude. On the other hand, tax cuts might generate crowding out. As consumers try to spend more, resources that would have previously gone to investment might now be redirected to consumption. Likewise, as consumers try to spend more, the extra goods might be provided by an increase in imports, lowering net exports.