Question

12. Consider an economy with a straight line PPF. Show how an increase in government spending paid for by an increase in lump sum labor taxes affects outcomes. Do the same for an increase in government spending financed by a proportional income tax. Explain, by add of a graph as well as an explanation, why one of these will have larger welfare effects for the same increase in government spending.

Answer 1

A PPF(Production Possibility Frontier) illustrates the allocative and productive efficiency, opportunity costs & fundamental problems. And if it represents as a straight line then opportunity costs can be the cause. If opportunity costs are constant then PPF will prouduc a straight line. This case reflects a situation where the resources are not specialised.

As we know that government has a power to mandate taxes. So if there is an increase in government spending then the govenment will increase taxes to extract more revenues. The amount collected through taxes doesn't find its ways into consumption. But if the government spends every dollar that it collects as a tax then it does find a way in government expenditures. Then if this is the case GDP remains unaffected. The size of the economy will remain the same whether people choose to produce or consume private or public goods. Spending policy is a mirror image of tax policy. If the government were to keep taxes the same but decreases the spending then it would have the same effect as a tax increase but through a slightly different channel. Income tax is a primary source of revenue for the federal government. Productivity declines as the tax rate increases as people choose to work less. Increase in taxes also reduce profits and ibceestmin but the magnitude of tax effect is smaller than those on the expenditure side. Workers in the private sector may react to the labor taxes. An increase in labor costs affect 1% of the GDP leads to the decrease in GDP investment. Fiscal expansions tend to be implemented largely through spending on publice sector.