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Unemployment forms one of the major government concerns in most countries and states of the world. In situations of elevated levels of unemployment, many people are left with no money to spend thus leading to low demand for products.
Decrease in demand makes many businesses and companies to go out of business or lay-off their workers as the level of unemployment grows. Through physical policy and multiplier effect, the government is able to manipulate the economy by controlling or managing demand levels (Slater, 2007).
According to Keynesian, reduction in tax manipulates aggregate demand thus stimulating or reviving the economy. When taxes are lowered, people remain with more money to spend thus increasing the aggregate demand for products. Increase in aggregate demand leads to rise in Real GDP thus reviving the economy (Sheffrin, 2003).
The issue of fiscal policy is entirely based on Keynesian economics as derived by John Maynard Keynes’ theories. According to Keynes theory, the government is capable of influencing the economy by either increasing or decreasing taxes and manipulating its spending level.
Manipulating government’s spending leads to change in position of the aggregate demand because the government forms part of the aggregate demand. By cutting taxes, the government increases disposable income of consumers. The consumers will now have more money in their pockets to spend.
This happens when the economy proves to be sluggish. When the public consumption or spending increases, more money is pumped into the economy leading to an expansionary effect.
On the other hand, reduction in the level of government’s spending and increase in taxes contracts the economy. “Therefore, expansionary fiscal policy which involves tax reduction and rise in government transfer payments shifts the aggregate demand curve to the right thus reviving the economy” (Larch, 2009, p. 125).
“Contractionary fiscal policy involves tax increase and reduction in government transfer payments thus shifting the aggregate demand curve to the left” (Larch, 2009, p. 126).
Considering Keynesian multiplier, the economy is supposed to encounter a rippled effect. This is due to funding by the government which increases level of consumption. Rise in consumption levels increases level of aggregate demand for products thus leading to growth of economy from recessionary period.
Keynesian suggests that growth of economy from recessionary period encourages employment (Heyne, 2002). This is because of high demand from people to consume more thus making supply firms to increase in number and hire more workers.
In multiplier effect, an increase in spending like rise in government outlays is actually a multiple of that increase and continues in the same trend until a potential is reached. “The increase in spending decreases considerably after every step making the multiplier process to tape-off and allow for equilibrium attainment” (Sheffrin, 2003, p.121).
In the case of closed economy, decrease in tax payments at these steps increases consumer spending and multiplier effect size thus increase in aggregate demand. This revives the economy.
In general, revival of economy largely depends on the aggregate demand. Tax reduction seems to be one of the actions that shift the aggregate demand curve. Reduction in taxes makes more money available to consumers thus leading to increase in consumption.
Increase in consumption is associated with increased demand for products and rise in spending levels. This pumps money into the economy leading to its revival. Fiscal policy and multiplier effect also affects aggregate demand thus stimulating the economy.
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Heyne, P. (2002). The economic way of thinking. Journal of economy, 6(2), 46-59.
Larch, M. (2009). Fiscal policy making in the European union. An Assessment of Current Practice and Challenges, 2(14), 121-127.
Sheffrin, M. (2003). Economics: Principles in action. Upper Saddle River, New Jersey: Pearson Prentice Hall.
Slater, S. (2007). Economics (9th ed.). London: Routledge.