Question

Any fiscal package proposed by Mr. Trump will probably cut corporate tax rates, reduce individual marginal rates, and broaden the tax base. This could be the biggest overhaul to the tax system since the Reagan reforms of 1986, which lowered households’ average marginal income-tax rates by 2 percentage points each in 1987 and 1988. Source: WSJ.

Refer to Article Summary 4.

All else equal, what will happen to the long-run equilibrium price level and real GDP in the USA? Explain and show graphically the effect of the aforementioned tax reform in an AD-AS diagram.

Answer 1

Cutting corporate tax rates, reducing individual marginal rates, and broadening the tax base should lead to an increase in the real GDP if the incentive effect of the tax cuts are greater than its negative effects, in the long run. The incentive effect refers to a positive increase in taxpayer's behaviour after a tax reduction be it in the form of more savings, working more etc. However, the negative effect of a tax reduction can lead to an increase in the budget deficit in the long run, or it can distort workers' supply behaviour etc.

If growth or real GDP increases in the long run, then the price level will also be higher.

Assuming that the tax reforms manage to stimulate demand (by increasing consumption, investment etc) AD would shift outwards leading to both higher GDP and a higher price level.

AS fI AD Л8