Equilibrium and Economic Policies
Of the both policies, the Tax Reduction is better policy as it stimulates the economy in a better way than government spending. Although there are number of reasons for my acceptance of policy of tax reduction. However, before coming to a conclusion we will be discussing below employment level output and then will evaluate the given policies to correct them.
When an economy is operating under below potential GDP level in such case it is said to be operating at Below Full Employment Equilibrium. It is a macroeconomic concept where an economy’s short run gross domestic level is lower than the long run potential GDP level and every economic policy is directed towards achieving output as close as possible to potential GDP related to long term because at the level below potential GDP, the resources are underutilized and the economy is likely to experience recessionary period with major impact on employment levels. Before moving ahead to discuss the government policies to move the economy towards potential GDP , we will discuss the whole situation in a diagram:
An economy achieves short run equilibrium when Aggregate Supply(AS) intersects Aggregate Demand Curve(AD). The intersection level determines the output level in short term. The below diagram , point E is the level of Equilibrium, while Y is the level of Actual Output while Y’’ is the potential output.
The above diagram shows that though the economy is in short term equilbrium but it is in long run disequilibrium because the level of short run equilibrium real GDP, Y, is less than full employment GDP(along the LAS Curve) and this will be interpreted as recessionary gap or below full employment equilibrium where economy will see high unemployment figures and the thus, the government in order to achieve output level close to potential GDP will implement policies in order to improve the economic condition and our discussion will move ahead with commentary on two of the economic policies and which is more relevant to change the business cycles.
Policy 1: Taxation Reduction:
Taxation cut is an important tool of fiscal policy of the government where in order to smooth the economic cycles government reduce the taxation rates which leads to rise in disposable income of the individuals are their taxation bill is reduced post tax reduction. With fall in taxation rates and rise in disposable incomes, the purchasing power of the individuals at macro level i.e in the form of aggregate demand will enhance. This will shift the aggregate demand to the right and businesses in order to increase their supply courtesy improved aggregate demand will employ more people and with simultaneous shift in aggregate demand and supply, a new equilibrium will be established near to long run potential GDP Level.
In another measure of the government to increase its spending on home energy retrofits to counter the recessionary period, government plans to improve the economic condition by increasing their spending on budgetary plans which in turn will increase the employment levels and finally the aggregate demand in the economy.
Comparing the Two Policies: Tax Cuts vs Government Spending
Though, both of these polices are part of fiscal decisions of the government where both through tax rate deduction and increase in Government Spending, government intends to smooth the business cycles. However, the policy of tax rate deduction is more effective and rational way of achieving economic stimulation. This is because increase in consumer spending and job opportunties is the core way of getting out of recessionary gap in the economy. This is because consumer spending is required to increase the rate of tangible growth in the economy and this cannot be achieved if the consumers/individuals are unemployed and on the other hand, new jobs cannot be created unless the rate of corporate taxes is not reduced as cut in corporate taxes will create incentive for the companies to create more jobs. Thus, a fall in taxation rate will simultaneously create new job opportunities and increase in consumer spending once they get employed.
In addition, the policy of reduction in taxation rates is preferable citing economic recovery as the forces of supply and demand can work more freely on their own under ules of low tax rates. Firms seeking Profits are more sensitive to demand than the policy of the government to increase their spending, seeking to employ and prop up. Thus, the policy of taxation cut will affect supply so that the market is cleared as supply and demand meet and wastefulness is minimized. This makes for a more efficient allocation of resources and a much more sustainable economy. Both are necessary to recover from a recession. Evident example of Efficiency of Cut in Taxation Rate was seen in US Economy, when it faced recession during 1919 and the federal government announced a series of tax cuts from 1919-1928 which kept the US Economy Stable and recession was over within two years of its inception. However, it was only after government spending increased during 1930 in response to stock market crash of 1929, that the US Economy entered the depths of Great Depression.
In order to move the economy close to potential GDP, the policy of tax cuts is the best strategy than Government Spending.
DebateWise. Tax cuts, not government spending, are the best way out of recession. n.d. Web. 4 December 2013.