Week 6 Homework Solutions
Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy’s built-in stability?
In a phrase, “net tax revenues vary directly with GDP.” When GDP is rising, so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments such as unemployment compensation and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP. A progressive tax system would have the most stabilizing effect of the three tax systems and the regressive tax would have the least built-in stability.
A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or a regressive tax. The latter rate would rise more slowly than the rate of increase in GDP with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax that falls, but more slowly than the progressive tax, as incomes decline.
Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. How might “politics” complicate fiscal policy? How might expectations of a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out effect, and why might...
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