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Economics: Theory Through Applications
27-1
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Chapter 27
Income Taxes
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Learning Objectives
•
What is the difference between a marginal and an average tax rate?
•
How does the tax system redistribute income?
•
What was the state of the economy prior to the Kennedy Tax Cut of 1964?
•
What framework did the economists at that time use to predict the
effects of this tax cut?
•
What was the response of the economy to this tax cut?
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When income taxes are cut, what happens to private saving?
•
When income taxes are cut, what happens to national saving?
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Learning Objectives
•
What was the state of the economy at the time of the Reagan tax cut?
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What framework was used for analyzing the effects of this tax cut?
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What were the effects of the tax cut?
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Figure 27.1 - Easy Tax Form
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Figure 27.2- Macroeconomic Effects of Tax Policy
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Basic Concepts of Taxation
taxable income  adjusted gross income   deduction  exemption 
taxable income  adjusted gross income   deductions and exemptions 
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Table 27.1 - Revised 2010 Tax Rate
Schedules
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Figure 27.3
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Marginal and Average Tax Rates
taxes paid  tax rate  income
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Table 27.2 - The Redistributive Effects of
Taxation (in US$)
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Figure 27.4 - Real GDP in the 1950s
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Figure 27.5 - Tax Policy During the Kennedy
Administration
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Consumption Smoothing
disposable income  consumption  saving
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The Consumption Function
consumption  autonomous consumption  marginal propensity to consume  disposable income
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Table 27.3 - Consumption, Income and
Saving
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Figure 27.6 - Consumption, Saving and
Income
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The Consumption Function
consumption
average propensity to consume 
disposable income
savings rate 
savings
disposable income
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Figure 27.7 - Consumption and Income
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Table 27.4 - Consumption and Income in the
1960s (Seasonally Adjusted, Annual Rates)
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Aggregate Income, Aggregate Consumption,
and Aggregate Saving
real GDP  multiplier  autonomous spending
change in real GDP  multiplier  change in autonomous spending
change in real GDP  multiplier  change in autonomous spending
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Tax Cuts and National Saving
national saving  private  government deficit
national saving  private saving  government surplus
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Figure 27.8 - Real GDP in the 1970s
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Figure 27.9 - Marginal and Average Tax
Rates, 1982 to 1984
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Labor Supply
leisure hours  working hours  24 hours
 leisure hours 
 leisure hours 
nominal wage   nominal wage income  24  nominal wage
nominal wage  
 price level 
consumption   24  nominal wage
leisure hours  real wage  consumption  24  real wage
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Figure 27.10 - Labor Supply
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The Effect of the Reagan Tax Cuts on the
Supply of Labor
 nominal wage 
disposable income  hours worked  (1  tax rate)  

 price level 
 hours worked  (1  tax rate)  real wage
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Figure 27.11 - Labor Supply Response to Tax
Cut
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Figure 27.12 - Laffer Curve
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Key Terms
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Marginal tax rate: The marginal tax rate is the tax rate paid on additional
income
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Average tax rate: The average tax rate is the ratio of total taxes paid to
income.
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Disposable income: Disposable income is equal to household income less
taxes paid
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Key Terms
•
Circular flow of income: The circular flow of income measures the money
flows among the different sectors of the economy as individuals and firms
buy and sell goods and services
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Multiplier: The multiplier equals one divided by one minus the marginal
propensity to spend and is key to understanding how a change in
autonomous spending effects output in the aggregate expenditures model
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Aggregate expenditure model: The aggregate expenditure framework
studies the relationship between planned spending and output
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Personal income: Personal income is the income in the economy that
flows to households
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Key Terms
•
Disposable income: Disposable income is equal to income minus taxes
paid to the government
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Consumption smoothing: Consumption smoothing is the idea that
households like to keep their flow of consumption relatively steady over
time, smoothing over income changes
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Consumption function: The consumption function is a relationship
between current disposable income and current consumption
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Key Terms
•
Marginal propensity to consume: The marginal propensity to consume is
the amount consumption increases when disposable income increases by a
dollar
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Marginal propensity to save: The marginal propensity to consume is the
amount saving increases when disposable income increases by a dollar
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Average propensity to consume: The average propensity to consume is
the ratio of consumption to disposable income
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Key Terms
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Savings rate: The savings rate is the ratio of household saving to
disposable income
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Exogenous variable: An exogenous variable is determined outside the
model and is not explained in the analysis
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Potential output: Potential output is the amount of real GDP the economy
produces when the labor market is in equilibrium and capital goods are
not lying idle
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Income effect: As income increases, households choose to consume more
of everthing, including leisure
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Key Terms
•
Substitution effect: As the real wage increases, household substitute
away from leisure towards consumption of goods and service and thus
supply more labor
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Time budget constraint: According to the time budget constraint, the
sum of hours worked each day plus leisure time each day equals 24 hours
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Real wage: The real wage is the nominal wage corrected for inflation
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Key Takeaways
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The marginal tax rate is the rate paid on an additional dollar of income
while the average tax rate is the ratio of taxes paid to income
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When the marginal tax rate is increasing in income, then the tax system
redistributes from rich to poor households. In this case, after tax income
is more equal than income before taxes are paid
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Beginning in the early 1960s, growth of real GDP began to slow
– This provided the basis for the tax cut of 1964
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The economists at the Council of Economic Advisors used the aggregate
expenditures model as the basis for their anlaysis of the effets of the tax
cut
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Key Takeaways
•
In response to the tax cut, consumption and real GDP both increased. This
fits with the prediction of the aggregate expenditure model
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Since the marginal propensity to consume is less than one, a tax cut will
lead to a household to consume more and save more
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National saving, the sum of public and private saving, will generally fall
when there is a tax cut
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Prior to the Reagan tax cut, the U.S. economy was experiencing both low
growth in real GDP and high inflation
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Key Takeaways
•
Reagan’s economic advisors stressed the effects of taxes on the supply
side of the economy, principally the incentive effects of taxes on labor
supply and investment
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The Reagan tax cuts lead to considerably higher deficits in the U.S.
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