Question

1. How will a change in taxation impact the AD curve? Explain and graph.

2.  What are the reasons why tax revenue increases and beyond a certain tax rate, decrease?

Answer 1

1. AD curve shows total quantity of goods and services demanded in an economy at different price levels.

AD is the sum of consumption spending, investment, government spending and net exports.

Suppose tax rises, disposable income will fall. So consumption Expenditure will also fall. Output level falls.

AD curve will shift left.

Similarly tax rate fall leads to rightward shift to AD.

2. Tax revenue is the tax rate times the output or quantity.

Initially as the tax rate rises, tax revenue rises. But after a certian point tax revenue starts falling because now people are discouraged to work for the taxed activity. So much so that the revenue actually starts falling as there is no incentive to work at too high tax rate. At this level reducing the tax rate increases the tax revenue.