¶ … lost in the numbers, so we'll keep the scenario as simple as possible. Just assume that overall taxes are cut by 10% across the board. What will this change do to disposable income, consumption, and the multiplier? What's likely to happen to equilibrium output and prices? How will the tax cut affect government revenues in the new equilibrium?
A tax cut will cause an increase in disposable income, as more income will remain in taxpayer's pockets, to be used at the consumer's discretion, rather than being funneled to the coffers of the government. This will likely cause an increase in spending and consumption, causing producers to produce more and charge higher prices, as consumer demand has increased and consumers have more income to pay higher prices. Producers will also have more available funds to invest in their infrastructure to meet increased consumer demand. Producers can also employ more workers and give raises to current employees, as well as allow current employees to work longer hours.
The multiplier will also increase as GDP increases with increased production and consumption. As producers produce, demand and supply increases, and prices increase, equilibrium output will increase. Government revenues, however, will decline because the government will have less money coming in through taxes. This may mean that the government will choose to spend less, employ fewer workers, and cut back more of its programs. However, if the economy continues to expand, the government may enjoy some of the benefits of increased production, as it will still gain revenue from worker's higher incomes and producer's larger sources of revenue. or, the government may chose to engage in deficit spending, as was common in the 1980s, when President Reagan instituted tax cuts to stimulate the economy, yet still increased the amount of government allocated to building up the military.
