Question

The House of Representatives recently passed what “will be the biggest tax cuts in the history of our country.” However, do tax cuts really work? Use the “Keynesian Cross” model to evaluate the effectiveness of cutting taxes by 10%. You should consider the effect of he tax cuts on GDP, employment, and the government’s budget. Is there an alternative proposal that would increase GDP by the same amount but have a smaller impact on the government’s budget?

Assume the US economy can be modeled as follows:

C = 3000 + .75Yd

I = 3500

G = 2000

t = .35

Answer 1

Y = C+I+G

Y = 3000 + .75 (Yd - 0.35Y) +3,500 + 2,000

Y = 8500 + .75Y -.26Y

Y(1-.49) = 8500

Y = 8500/ 0.51

= 16,666

Further tax is reduced by 10% , then new tax is 0.25

Y = 3000 + .75 (Yd - 0.25Y) +3,500 + 2,000

Y = 8500 + .75Y -.18Y

Y(1-.57) = 8500

Y = 8,500 / .43

= 19, 767

Total increase in GDP = 19,767 - 16,666

= $3,101

Further it will increase consumption as well since MPC = 0.75

Rise in consumption = .75*3101

= 2,325

government budget defiict will rise due to fall in tax rate and rise in tax collection due to rise in GDP would not be sufficient to compensate losses.

Value of expenditure multiplier is alway greater than the value of tax multiplier. Hence, GDP would have increased more, had government resorted to increase aggregate expenditure.