Household Income Tax Increase
The question
The economy of Vireska has been growing rapidly and prices are climbing quickly. Vireska's legislature raises the personal income tax rate paid by households, reducing the take-home pay families have available each month. Assume the central bank takes no action and that nominal wages set in existing labor contracts do not change. Show the effect of this policy on Vireska's economy in the short run, holding all else constant. Show the effect on the Fiscal Policy (AD-AS) graph.
Equilibrium at Real GDP (Y) 92, Price Level (PL) 66
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Household Income Tax Increase: the worked answer
On the Fiscal Policy (AD-AS) graph, AD shifts left.
Why AD shifts left
A higher personal income tax rate lowers households' disposable income, and with less take-home pay households consume less at every price level. Consumption is the largest component of aggregate demand, so aggregate demand shifts to the left, and the tax multiplier magnifies the initial cut in spending, though by less than a spending multiplier because part of the tax is paid out of saving rather than consumption. The tax falls on household earnings, not on units of output, and nominal wages are fixed by contract, so short-run aggregate supply does not move; resources and technology are unchanged, so long-run aggregate supply stays put.
What happens to the equilibrium
The equilibrium price level falls and real GDP decreases.
The mistake students make on this one
A very common wrong answer shifts short-run aggregate supply to the left, because a tax feels like a cost and students remember that higher costs move SRAS. This tax is levied on what households earn, not on each unit a firm produces, so no firm's per-unit cost changes. The SRAS drawing also predicts a rising price level, which is the opposite of what a policy designed to cool inflation is supposed to do, so it fails its own sanity check.
On exam day
Sanity-check the direction before you move on: a policy meant to cool inflation has to pull the price level down in your drawing, so if the curve you moved pushes it up you shifted the wrong one.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when AD shifts left and every other curve on the Fiscal Policy (AD-AS) graph stays where it started — the same standard an AP reader applies to a drawn graph: the right shift, and nothing extra. There is no AI involved; the rubric is the geometry.
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