Fiscal Policy Impact of Tax changes in the National Budget

Fiscal Policy: Impact of Tax changes in the National Budget
Fiscal policy is a term that is commonly used in economics and political
sciences referring to the policies that guide the government in revenue
generation and expenditure. In this respect, the government can utilize
two main instruments namely tax policy and the government spending to
regulate the economic growth and development. A well stricken balance
between the government expenditure and revenue generation results in
equitable distribution of national wealth, increase in aggregate demand,
and fair allocation of resources. Although the government has several
sources of generating income (including seigniorage, borrowing, fiscal
reserve, and sales), tax is the main source of income for all
governments in the world (Alison, 2009). To this end, the effectiveness
of the tax policy largely determines the capacity of the government to
control the national economy. The design of an effective tax policy
requires concerted efforts of experts in different fields not excluding
economists and political scientists. This results in an effective
prediction of the potential impact of the policy and its capacity to
reduce incidents such as deadweight loss. This paper will address the
impact of changes in income tax legislation on the economy and federal
budget with a keen focus on the Bush tax act.
Effect of changes in tax on aggregate demand and supply
The concept of aggregate demand is used to measure the economic progress
by evaluating the total demand for goods and services in the economy.
The aggregate supply, on the other hand, refers to the total output
contributed by all producers in the economy. The components of aggregate
demand and aggregate supply model are used in the measurement of
economic performance by evaluating the relationship between the national
output and the price of goods and services. The basic principle behind
the application of this model is that changes in the price of goods and
services affect the level of total output achieved. Similarly, the level
of commodity prices is affected by changes in other factors such as tax,
interest rate, and rate of inflation (Blanchard, 2009). In the aggregate
demand concept, the relationship between the commodity price and total
output can be explained by an inverse relationship. An increase in price
results in a decrease in total output while a decrease in price leads to
increases the total output. The output and commodity prices have a
positive relationship with the aggregate supply concept. An increase in
national output leads to increase in price of commodity while a decrease
in output results in a decrease in price (Funk, 2010). The equilibrium
output and price of goods and services are achieved when the aggregate
demand and aggregate supply curves intersect at a point that reflects
the gross domestic product.
Change in tax policy is one of the factors that affect the economic
significantly by influencing the levels of aggregate demand and
aggregate supply. In the aggregate demand concept, a reduction in tax
has two affects including the increase in people’s disposable income
and a decrease in the price of goods. An increase in disposable income
and the decrease in commodity prices result in an increase, in the
amount spent on consumption. An increase in the tax level, on the other
hand, reduces a person`s disposable income, which results in a
decrease in the amount spent in the economy (Alison, 2009).
Consequently, this decreases the gross domestic product. The interplay
of these variables is illustrated in Figure 1.
Figure 1: Effect of changes in tax on the national output in the
aggregate demand approach
Source: Alison (2009)
Graph 1 shows that a tax cut results in an increase in disposable
income, which leads to increase aggregate demand. This leads to a shift
in aggregate demand curve to the right (new demand curve AD) and an
increase in the national output. On the other hand, an increase in the
tax level reduces the disposable income of the citizens, thus reducing
the aggregate demand. This leads to a shift in the aggregate demand
curve to the left side and a decrease in the national output.
The concept of aggregate supply is used to determine the effect of tax
on the consumer surplus and producer surplus. Producer surplus is
determined by subtracting the amount that producer needs to charge to
earn a profit from the amount charged for the product. On the other
hand, the consumer surplus is determined by the subtracting the amount
that a consumer is willing to pay from the amount that the consumer is
able to pay for the same commodity (Funk, 2010). Tax cuts results in
incidence in which amount of commodity supplied intersects with the
demand for the commodity at a lower price. Consequently, this results in
an increase in the national output. During an increase in taxation
level, on the other hand, supply intersects the level of demand at a
high price resulting in a decline in national output. As shown on Figure
Figure 2: Effect of changes in tax on the national output in the
aggregate demand approach
Source: Funk (2010)
An equilibrium situation is arrived at when the business cycles manage
to establish the optimum level for both the aggregate demand and
aggregate supply as shown in Figure 3. The equilibrium output represents
the gross domestic product (Blanchard, 2009).
Figure 3: Equilibrium output
Source: Blanchard (2009)
Bush tax cuts
Bush tax cut refers to a series of temporary relief on the income tax,
which were initiated by George Bush, the former president of the United
States. The tax acts that resulted in significant changes in the tax
code were enacted between 2001 and 2003. The two substantial tax cut
legislation includes the Economic Growth and Tax Relief Reconciliation
Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of
2003 (Hungerford, 2010). However, the subsequent tax cut legislation
mainly targeted at extending the two tax cut acts up to 2010. The main
goal of the two acts was to reduce the rate of unemployment and improve
economic growth using the tax policy as a fiscal measure of economic
growth and development. This was accomplished by amendment of the
Internal Revenue Code and the Alternative Minimum Tax provisions
(Singer, 2012). The amendments resulted in the elimination of the many
tax deductions, thus reducing the opportunities for the wealthy taxpayer
to reduce their tax burden by utilizing the legally recognized
incentives. On the other hand, a reduction in the rate of several
classes of tax (including federal income tax, capital gains tax,
dividend income tax, and marriage penalty) benefited lower income
taxpayers (Hungerford, 2010).
Table 1: Federal budget and budget deficit for 2009, 2010, 2011, and
Total budget (trillion dollars) Budget deficit (trillion dollars)
Total revenue Total expenditure
2009 2.105 3.518 1.413
2010 2.165 3.721 1.267
2011 2.314 3.630 1.56
2012 2.469 3.796 1.327
Source: Singer (2012)
The spirit of the Bush tax cuts was to reduce the tax burden on the
lowly paid citizens and motivate them to save and invest. However, many
economic and political analysts view it as a political weapon between
the Democrats and the Republicans. This is because, the legislation had
extremely short-term benefits compared to the alleged benefits.
According to Pollack (2012) the designers of the policy had no bottom-up
analysis of the act’s capacity to improve the economy. The Bush tax
act had three impacts that reduced its effectiveness in achieving the
intended goals. First, implementation of the act distorted the income
distribution in the United States. Although the high tax cuts in terms
of percentage targeted the low income earners, the aggregate reduction
in the tax went to the rich and wealthy families. According to Soltas
(2012) the Bush tax cuts had a hidden regressive impact that the policy
makers failed identify at the early stages of its enactment.
Secondly, the Bush tax cuts failed to capture the requirements for
economic growth in the present world economic situation. According to
Thoma, (2012) the indicators of economic growth (including job creation,
investment, growth in the gross domestic product, and employee
compensation) experienced the first decline from 2001 to 2007 since
1947. The Bush tax cuts were the main contributing factors of this
deterioration of economic growth and development. The Bush tax cuts
failed to appreciate the current economic situation because the
employment creation policies should target the economic factors (such as
a demand shortfall) that hold full economic recovery. The Bush tax cuts,
on the other hand, targeted the taxpayers whose main agenda would be to
save the extra amount resulting from the tax cuts and rarely invest to
contribute towards economic growth and job creation (Pollack, 2012).
Effect of tax on Budget deficit
Budget deficit occurs when the amount of money that the government
spends or expects to spend over a given period exceeds the amount of
revenue collected on the amount that the government expects to collect
within the same period. Tax is the main source of revenue for many if
not all governments in the world. In this respect, a reduction in tax
rate reduces the amount of revenue collected, thus expanding the gap
between revenue and expenditure. On the other hand, an increase in tax
rate enables the government to collect more revenue and increases its
capacity to reduce the budget deficit (Ruffling, 2013). However, the net
effect of changes in tax rate depends on the whether a change in the tax
rate is accompanied by a change in government spending. For instant, if
government spending is reduced by the same amount as the tax revenue,
there will be no effect on the budget deficit. Similarly, the Bush tax
cut was the key factor that resulted in an increase in the federal
budget deficit. Although the spirit of the Bush tax cuts was to help the
low incoming earning population by reducing the tax burden and reducing
the opportunities for the wealthy tax payers to overuse incentives, the
outcome was a different case. This is because the tax cuts reduced the
government revenue to the unforeseen extent, thus inflating the budget
deficit (Ghilarducci, 2011). The incentive given to the rich taxpayers
by reducing the tax rates is minimal, but a small reduction in the tax
rate results in a huge loss of revenue generated from the wealthiest
taxpayers. Research has shown that the Bush tax cuts lead to increase in
the deficit and the deficit will continue increasing as shown in Figure
Figure 4: Impact of Bush tax cuts on budget deficit
Source: Singer (2012)
The decision on whether to extend the Bush tax cuts or let them expire
A study has shown that expiration of the Bush tax cuts will yield
progressive results, as opposed to the regressive nature of the act
(Thoma, 2012). This is because, upon the expiry of the act the take home
income of the low income earners is expected to reduce by only 0.5 %, 2
% of the middle-income earners, 4.1 % of the upper medium income
earners, and 6.4 % of the top 1 % income earners. This implies that the
tax cuts policy should be left to expire in order to restore the
distorted income distribution in the economy. Additionally, economic
analysis indicates that the Bush tax cuts have continued to increase the
national debt since the enactment of the first act of the Bush tax cuts
policy (The Economic Growth and Tax Relief Reconciliation Act of 2001).
According to Soltas (2012) the Bush tax act had added a total debt of $
3.4 trillion to the national budget from 2001 to December 2012, which
accounted for about 40 % increase in the national debt. This resulted in
an additional financial cost to the people of the United States of
America in term of interest of $ 65 billion in the year 2012. In
addition, Pollack (2012) suggested that if the tax cuts are will be
extended, they will result in an additional debt of $ 4.3 trillion to
the federal budget by 2020. Expiry of the tax cuts policy will reduce
the national debt and the budgetary deficit, thus saving the economy.
This will mark the beginning of economic recovery marked job creation,
increased investment, and employee compensation.
The effect of the Bush tax cuts has been an increase in the deficit.
Although the original intention (increasing the take home pay for the
middle income earners) of the policy have been partially achieved,
research has shown that an attempt to extend the tax cuts will continue
increasing the deficit. This scenario is expected to continue up to
2020, beyond which the rate of increase in deficit may be unbearable
(Goldfarb, 2013). To this end, the Bush tax cuts should be left to
expire because this is one of the most viable means of increasing the
government revenue and reduce the deficit.
Fiscal policy is an effective tool used to regulate the balance between
government income and expenditure. However, the net impact of any fiscal
policy depends on the capacity of the policy makers to predict its net
impact with relative accuracy. Tax policy is one of the fiscal measures
that can be used to adjust the level of deficit because the tax
constitutes the largest source of income to the government. Tax
reduction may be an incentive for the citizens because it results in an
increase in take home income, savings and investment. However, the
government should be able to weigh between the incentive achieved by the
policy and its impact on the amount of the deficit and the entire
economy. Tax cuts, as illustrated in the Bush tax cuts, have little
incentive on the highest tax payers, but the ultimate loss of revenue to
the government exceeds the expected benefits.
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