Question

Suppose an economy starts out below potential output instead of at potential output. Moreover, suppose that after a tax cut, the economy is still below potential output in the short run. What are the main benefits of the tax cut in this case?

Answer 1

If economy is below potential output, there occurs a recessionary gap in the economy. When tax cut, consumers disposable income rises which raises the aggregate demand in the economy. Even after tax cut and rise in aggregate demand, economy is still below potential output. Tax cut will reduce the recessionary gap in the economy and reduce the fear of recession in the economy. Additionally, tax cut will leave more cash in hands of public raising circulation of money in the economy.