Question

Comparing two policies: a tax cut that last one year, or a tax cut that is the same size this year, but will continue permanently. Looking at only consumption in this year, would you expect the two policies to have the same effect on consumption in this year, or for one of the policies to have a larger effect? Briefly explain

Answer 1

In Case of tax xut for only one year the consumers know that the tax cuts is only for a limited period and hence they will not spend the amount saved as a result of tax cut, But in case the tax cut is expected to be permanent then the consumers will consider the amount saved tax cut as forever and will try spending more money and which will result in grater impact on Aggregate demand. A temporary tax cut that will last for ane year and will have lower disincentive to cut consumption and hence willl stimulate greater spending by the consumers in the long run as compared to a permanent tax cut . With a temporary tax cut, people know that this is a temporary reduction in their disposable income and hence in the long run the disposable income will be the same as before the tax cut and consequently, the reduction in consumption level is low in the long run.