How does the reduction in income taxes change the incentive to work?

Trump has consistently pursued policies aimed at stimulating the economy. On the regulatory side, his administration has worked to reduce regulation on corporations and banks. On the fiscal side, the president supported and signed the tax cut act of 2017 reducing personal and corporate income taxes (among other things). And on the monetary policy side, he has actively criticized the central bank’s ”tight” monetary policy approach and called on the Federal reverse to reverse course, which it did in 2019.1 Additionally, he has picked Cain and Moore, who both support lowering interest rates, for the current Federal Reserve Board openings. In this question you will consider the pros and cons of some of these policies through the lens of the models you have learned this semester. He has also been a strong proponent of renegotiating trade deals that are more fair for the United States and has engaged with a tit for tat tariff dispute with China.

1. The reduction in taxes changes the incentives for firms to invest and workers to work.

a. How does the reduction in income taxes change the incentive to work?

b. Use a simple supply and demand model (like on page 30 of chapter 15 slides) to show the effects of the tax cut on quantity of labor employed.

c. How should this effect output (think about in terms of chapter 12 concepts)?

d. The reduction in corporate taxes raises the after tax return on capital, which in turn increases investment. How should this affect output in the future?

2. Let us now turn to the short run model, to study the effects of the tax cuts. Use the AD/AS model and the Phillips Curve to answer these questions.

a. How will the reduction in income taxes affect consumer spending?

b. Use the AS/AD model to show the short run effects of the reduction in income taxes.

c. What will happen to the output gap and inflation in the short run?

d. What will happen to the output gap and inflation in the long run?

e. Now add in the drop in corporate taxes leading to more investment demand. What happens to the output gap and inflation?

3. Next we turn to the effects of the President’s efforts to reduce interest rates on the economy.

a. To keep inflation stable, how should the Federal reserve respond (in terms of the real interest rate) to the drop in taxes?

b. Show the effects of this response in the AS/AD diagram and on the Phillips Curve.

c. Now assume, due to executive pressure and new appointments to the board, the central bank instead cuts interest rates. Show the effects of this response in the AS/AD diagram and on the Phillips Curve.

d. What is the effect of executive pressure to lower interest rates on the economy?

4. Next, let us turn to the long run effects of increasing the deficit.

a. Use the model of the market for loanable funds to explain what will happen to investment.

b. How will this affect output in the future?

c. In the long run the government must run a balanced budget. What do tax cuts today imply for future government services and taxes?

5. Let us now combine all of the effects together.

a. According to our models, what should be the net effects of the president’s policies in the short run and in the long run. Summarize and combine your answers from the previous four parts.

b. Write approximately a paragraph discussing whether you think the President’s policies are good for the economy. There is no right answer as that will depend on your value judgments of the various costs and benefits, but should be a rational argument. In answering this question, you may also bring in other things that are not covered by out models (for example inequality).

6. Next, let us turn to the President’s efforts to reduce the trade deficit with China.

a. Assume the U.S. imposes tariffs on Chinese textile goods. Use the concepts of consumer surplus and producer surplus to show that tariffs will reduce net welfare in the US.

b. Who will be the winners and losers in the US from higher textile import tariffs?

c. Now assume, China retaliates by imposing tariffs on US cars. How will this affect U.S. welfare? Who wins? Who losses?

d. Now apply the ideas from the previous three sub-parts to the broader U.S. – China trade policy under the current president. Who does it benefit? Who does it hurt? Does it increase the welfare of the average person?

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