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JA8. Fiscal Policy and its Effects on GDP

Statement

In at least three well composed paragraphs, please describe the effect that changes in business taxes, personal income, and transfer payments have on a country’s gross domestic product (GDP).

Answer

A Fiscal Policy is a government decision to influence economic conditions by changing one or more of business taxes, personal income (through personal income taxes), and transfer payments. These changes can have a significant impact on a country’s GDP as it shifts the aggregate demand curve either to the right (increasing GDP) or to the left (decreasing GDP). Automatic stabilizers are known fiscal policies that are built into the economic system and they will trigger automatically when the economy is in a recession or expansion. For example, unemployment benefits; when the economy is in a recession, more people are unemployed and automatically entitled to unemployment benefits that will reduce the impact of the GDP decrease (Rittenberg & Tregarthen, 2009).

Discretionary fiscal policy is another type of fiscal policy that is deliberate and requires government action. For example, a one-time tax cut imposed after political debate. The text will describe the effects of changes in business taxes, personal income, and transfer payments on a country’s GDP regardless of wether the trigger of the change is automatic or discretionary. However, usually, discretionary fiscal policies have more concentrated effects on GDP than automatic stabilizers.

An increase in business taxes will reduce the profits of firms and therefore reduce the amount of money put into investments and hiring; reducing overall consumption and investment (both are components of GDP). This will shift the aggregate demand curve to the left, decreasing GDP. On the other hand, a decrease in business taxes will increase business profits and investments, shifting the aggregate demand curve to the right, increasing GDP.

An increase in personal income taxes will reduce the disposable income of households, reducing consumption and shifting the aggregate demand curve to the left. A decrease in personal income taxes will increase disposable income, increasing consumption and shifting the aggregate demand curve to the right (increasing GDP). An increase in personal income without a change in the tax policy will have little effect on GDP as greater income will be subject to higher taxes.

Transfer payments are payments made by the government to individuals who do not have to provide goods or services in return such as employment benefits or medical insurance for the poor. An increase in transfer payments will increase disposable income, increasing consumption and shifting the aggregate demand curve to the right (increasing GDP). A decrease in transfer payments will reduce disposable income, reducing consumption and shifting the aggregate demand curve to the left, decreasing GDP.

To conclude, each of the three changes mentioned in the question will have an effect on consumption, shifting the aggregate demand curve to the right or left, and therefore affecting GDP; but each through a different mechanism. Business taxes mainly affect investments, personal income taxes affect disposable consumption, and transfer payments affect government spending. Investment, consumption, and government spending are all components of GDP; which is measured by the sum of these components; hence, changes in these components will affect GDP accordingly.

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