Chapter 11: Problem 44

Compare two policies: a tax cut on income or an increase in government spending on roads and bridges. What are both the short-term and long-term impacts of such policies on the economy?

Short Answer

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In the short term, both a tax cut on income and an increase in government spending on roads and bridges can boost GDP and employment by increasing disposable income and aggregate demand. However, in the long term, the impacts diverge. A tax cut on income may not guarantee sustained GDP growth or employment, as its effects on the economy depend on various factors like consumption versus investment, and other external influences like technology and globalization. In contrast, increased government spending on infrastructure typically results in improved productivity and efficiency, leading to sustained economic growth and job creation in the long term. Ultimately, the preferred policy depends on a government's specific objectives and priorities.

Step by step solution

1. Introduction

Before diving into the analysis, we first need to understand the nature of the policies being compared. A tax cut on income is a fiscal policy whereby the government reduces the income tax rate, giving individuals and businesses more disposable income. An increase in government spending on roads and bridges is also a fiscal policy and involves the government allocating funds to infrastructure projects, which create jobs and boost economic activity. Now that we have the basic understanding, let's examine the short-term and long-term impacts of these policies.

2. Short-term impact on GDP

In the short term, both policies can affect the Gross Domestic Product (GDP) of the economy. A tax cut on income may increase consumption and investment as individuals and businesses have more disposable income. The increase in consumption and investment leads to a higher aggregate demand, which in turn raises the GDP. An increase in government spending on roads and bridges also boosts aggregate demand in the short term. With more investments in infrastructure projects, construction companies and suppliers will receive more revenue, and they will spend this additional income on various goods and services, thereby raising total output.

3. Short-term impact on employment

Both policies affect employment in the short run. A tax cut on income may lead to higher consumption and investment, creating a demand for more goods and services, which in turn generates more job opportunities. An increase in government spending on roads and bridges creates direct jobs in construction and related sectors and can lead to increased demand for labor in those industries. This then causes an increase in employment in other sectors, as the additional income generated in the construction industry subsequently contributes to higher consumption and demand for goods and services.

4. Long-term impact on GDP

In the long term, the effects of both policies on GDP can differ significantly. A tax cut on income could potentially translate to an increase in GDP, but the extent to which this occurs would largely depend on the size of the multiplier effect and whether the tax cut is directed towards consumption or investment, with the latter being more efficient in the long run. An increase in government spending on roads and bridges could improve the productivity of the economy in the long run, as better infrastructure enables increased efficiency in transportation and logistics, leading to increased output and economic growth.

5. Long-term impact on employment

In the long term, a tax cut on income may not necessarily lead to a sustained increase in employment, as the relationship between taxes and job creation can be complex and affected by other factors like technological progress and global economic trends. An increase in government spending on roads and bridges can have a more direct long-term impact on employment, as improved infrastructure leads to increased productivity and efficiency in the economy, which can lead to long-term job creation.

6. Conclusion

Both policies—tax cut on income and increase in government spending on roads and bridges—yield different short-term and long-term impacts on the economy. While both can stimulate GDP and employment in the short term, their long-term effects may differ significantly. A tax cut on income can lead to increased GDP growth, but the extent of its impact may be uncertain and depend on various factors. On the other hand, increased government spending on roads and bridges ensures productivity and efficiency improvements in the long term, potentially leading to sustained economic growth and job creation. Ultimately, the choice of policy depends on the specific objectives and priorities of the government.

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