Question

In the simplified model with proportional taxation there can be two equilibria, one with a high tax rate and one with a low tax rate. Now, suppose that government spending increases. Determine the effects of an increase in G on consumption, leisure, labor supply, real output, and the tax rate in a high-tax-rate equilibrium and in a low-tax-rate equilibrium. How do your results differ? Explain why.

Answer 1

Equilibria with high tax rate.

• In high equilibrium tax system, taxes are already high. Increase in government expenditure, make it mandatory to raise the revenue resources.
• Tax rates will decrease.
• Due to income effect both consumption and leisure increases but while considering substitution effect, more expenditure leads to more employment and its results in to more consumption but side by side leisure is sacrificed.
• Tax base witness rise. Output rises but leisure comes down.

Equilibria with low tax rate:

• Increase in government spending leads to the rise in the tax rates to raise revenue resources.
• Increase in taxes leads to the fall in consumption and output.
• Thus, there may be rise in amount of time spent as leisure.