Tax cuts have been employed in the government’s fiscal policy especially during times of economic slowdown to revive the economy. When the economy is slumping, the people’s consumption power also slumps. The aggregate demand for goods and services in the market also falls. This creates a shock wave which hits industries like manufacturing, the housing sector and the service industry hard, leading to rising levels of unemployment (Toomey & Soloveichik 2009).
At such a time, a cut in taxes becomes one of the mechanisms available for pumping some life into the economy. Tax cuts for economic revival target especially people in the lower and middle classes. When implemented, tax cuts increase the amount of disposable income, that is, income after taxation, in the pockets of these people. Disposable income is perhaps the most critical factor in consumption.
The availability of more money to spend in the pockets of the masses raises the aggregate demand for goods and services, creating jobs in the various sector of the economy therefore increasing the Gross Domestic Product (GDP) (Toomey & Soloveichik 2009), a key indicator of the state of the economy. A cut in taxes works like a raise in salary. Tax cuts take effect through the multiplier effect which can be defined as the ratio of change between aggregate economic output (represented by the GDP) and a change in taxes since not all disposable income after a reduction in taxation rates actually translates to direct consumption.
The multiplier, obtained by multiplying the marginal propensity to consume with the expenditure multiplier, is used as an indicator to the change in fiscal policy induced government taxes required to result to a desired level of aggregate output. If coupled with increased government expenditure on services like health and education (which could actually be termed as an integral part of the cuts or economic stimulus package), tax cuts can revive the economy (Toomey & Soloveichik 2009).
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