Macroeconomic Effects of Tax Policy

Any change in the income tax regime affects both the spending and the supply sides of the economy. Our reason for thinking separately about the Kennedy and Reagan tax experiments is to isolate the spending effects and the supply effects. Once you understand these different channels, you will be equipped to evaluate other tax policies, such as those adopted later by President George W. Bush. Finally, the figure reveals that the choice between consumption and saving and the choice between work and leisure are at the heart of our analysis. 12.1 Basic Concepts of TaxationIf your financial situation is very simple, you can file this EZ form. However, if you receive income from other sources (such as dividends on stocks), or if you wish to “itemize” your deductions (for payments of interest on home mortgages, dependent children, property taxes, and so forth), you have to file a more complicated form, often with several other forms containing supplementary information. Thus the calculation of adjusted gross income and deductions can be quite complex. For all individuals, however, the basic relationship still holds: taxable income = adjusted gross income − (deductions and exemptions). Once you know your taxable income, there are then different tax rates for different income levels. [1] Marginal and Average Tax Rates From the perspective of macroeconomics, this complexity is daunting, particularly when we remember that the details of the tax system vary from country to country and year to year. The income tax is evidently not a simple thing that can be incorporated in a straightforward way into our frameworks. We cannot hope to incorporate all these features of the tax code into our theory without getting completely bogged down in the details. If we are going to make sense of how taxes affect consumption behavior, we must leave out most of these complicating elements. The challenge for economists is to decide which features of the tax system are critical for our analysis and which are peripheral and can be safely ignored. One noteworthy feature of the income tax system is that not everyone pays the same amount of tax.