Question

What is the impact on current consumption of a temporary tax cut according to:

a.	the Keynesian consumption function?
b.	the permanent-income hypothesis?

Answer 1

According to the consumption function determined by Keynes, consumption depends upon current disposable income. Current disposable income depends upon current taxes and transfers. If there is a temporary tax cut, it is going to increase disposable income and this will increase current consumption. Therefore current consumption is increased when there is a temporary tax cut.

According to permanent income hypothesis, permanent consumption depends on permanent income where permanent is different from transitory which is temporary. This indicates that if there is a temporary tax cut, it will increase the transitory income but this will have no effect on permanent income and therefore permanent consumption will not change. current consumption which is derived from permanent income will remain unchanged.