Question

A new President and Congress increase personal income taxes.

-Inflation: (increase/decrease)

-Real GDP: (increase/decrease)

Which ceteris paribus change could have caused the shift?:

Answer 1

Inflation: decrease

Tax reduces disposable income, which requires for consumption spending. Therefore, increasing tax decreases such spending; there is a decrease in purchase motive – since people don’t have enough money, they don’t go for purchasing. It reduces the price level and inflation – inflation should decrease.

Real GDP: decrease

Real GDP is the aggregate of consumption spending (C), investment spending (I), and government spending (G).

Real GDP = C + I + G

Since consumption decreases because of increasing tax, it decreases real GDP too.

Cause: Consumption spending (C)

This is the reason why read GDP is down because of tax increase. It shifts the curve to the left and makes the price level down.