Corporate Profits Tax Hike
The question
The legislature of Rensfeld enacts a large permanent increase in the tax on corporate profits, so a firm now keeps a much smaller share of the earnings that any new factory or machine it builds would generate. Assume household saving at each real interest rate is unchanged, and assume the government spends all of the additional revenue so that its budget balance is unchanged. Show the effect of this policy in Rensfeld's loanable funds market. Show the effect on the Loanable Funds Market graph.
Drag a curve, or use the arrow buttons. Want the free-play version with every control? Open this graph in the sandbox.
Corporate Profits Tax Hike: the worked answer
On the Loanable Funds Market graph, Demand for loanable funds shifts left.
Why Demand for loanable funds shifts left
A firm finances a capital project only when the return it expects to keep exceeds the cost of borrowing. A permanently higher tax on profits lowers the after-tax return on every prospective factory and machine, so fewer projects clear that bar at any real interest rate and firms want to borrow less, shifting the demand for loanable funds to the left. Household saving and the government's budget balance are unchanged by assumption, so the supply of loanable funds stays put.
What happens to the equilibrium
The equilibrium real interest rate falls and the equilibrium quantity of loanable funds decreases.
The mistake students make on this one
Many students shift supply right, reasoning that the government now collects more revenue and therefore saves more. The stem holds the budget balance fixed because the extra revenue is fully spent, so no public saving is created; the tax bites on the return to new capital, which is exactly what firms borrow to finance.
On exam day
Ask whose return the tax bites before you draw. A tax on the return to new capital moves the borrowing side, a tax on the return to saving moves the lending side, and the two shift opposite curves in opposite directions.
How this is graded
The checker reads every curve's position before and after your answer. You are marked correct only when Demand for loanable funds shifts left and every other curve on the Loanable Funds Market 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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