Question

According to the supply-side view of fiscal policy, if the impact on total tax revenues is the same, does it make any difference whether the government cuts taxes by either reducing marginal tax rates or increasing the personal exemption allowance? i. No, both methods of cutting taxes will exert the same impact on aggregate supply. ii. No, people in both cases will increase their saving, expecting higher future taxes, and thereby offset the stimulus effect of lower current taxes. iii. Yes, the lower marginal tax rates alone will increase the incentive to earn marginal income and thereby stimulate aggregate supply. iv. Yes, interest rates will increase if marginal tax rates are lowered, whereas they will tend to decrease if the personal exemption allowance is raised.

Answer 1

Yes, the lower marginal tax rates alone will increase the incentive to earn marginal income and thereby stimulate aggregate supply. (which is Option iii)

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Explanation:

A reduction in marginal tax rate will result in more/additional income in the hands of taxpayers which in turn will provide them with the incentive to spend more of their time on work (supply side effects of fiscal policy), that is, work harder to earn marginal income. In comparison to demand side effects of fiscal policy where a reduction in marginal tax rates would result in an increase in aggregate demand (because of extra spending on goods/services), the supply side effects of fiscal policy would result in an increase in aggregate supply (because of people working more). Therefore, Option iii is correct.