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Mych15b - Chapter 15 Government spending and its...

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Chapter 15 Government spending and its financing (Conclusion) 1.Fiscal policy: incentives, tax reforms and tax distortion 2.Deficits and debt 3.Deficits and inflation 1
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Fiscal policy: incentives, tax reforms and tax distortion Tax rate and incentives Y T(Y) T/Y : Average rate 2
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Fiscal policy: incentives, tax reforms and tax distortion Tax rate and incentives Y T(Y) T/Y : Average rate dT/dY : Marginal rate 3
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Fiscal policy: incentives, tax reforms and tax distortion Tax rate and incentives Households w N NS Income Effect Raising Average Rate 4
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Fiscal policy: incentives, tax reforms and tax distortion Tax rate and incentives Households w N NS Income Effect Raising Average Rate Raising Marginal Rate w N NS Substitution Effect 5
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Fiscal policy: incentives, tax reforms and tax distortion Tax reform in the 1980s Application: Labor supply and tax reform in the 1980s Congress reduced tax rates twice in the 1980s At the beginning of the decade the highest marginal tax rate on labor income was 50% The 1981 tax act (ERTA) reduced tax rates in three stages, phased in until 1984 The tax reform of 1986 further reduced personal tax rates, dropping the top marginal tax rate to 28% Supply-side economists promoted the tax rate reductions, arguing that labor supply, saving, and investment would all increase substantially 6
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Fiscal policy: incentives, tax reforms and tax distortion Tax reform 1981 Both marginal and average tax rates declined in the 1981 tax cut The decline in the marginal tax rate should lead to increased labor supply The decline in the average tax rate should lead to decreased labor supply The overall effect is ambiguous and may be small ??? The data suggest little effect, as the labor force participation rate didn’t change much after 1981 !!! 7
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Fiscal policy: incentives, tax reforms and tax distortion Tax reform 1986 8 The 1986 tax reform lowered marginal tax rates on labor income and raised average tax rates Both should lead to increased labor supply
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