A Payroll Tax Increase Cools Spending
A higher payroll tax cuts take-home pay and consumption, so aggregate demand falls, with part of the tax increase absorbed by lower saving.
A Payroll Tax Increase Cools Spending
Fiscal Policy (AD-AS)A higher payroll tax cuts take-home pay and consumption, so aggregate demand falls, with part of the tax increase absorbed by lower saving.
Equilibrium at Real GDP (Y) 92, Price Level (PL) 66
Below potential when the tax rises
The economy starts with AD crossing SRAS to the left of LRAS, so real GDP is below the full-employment level of output. The tax increase is aimed at the trust fund, not at the business cycle, which is what makes its effect on output worth tracing.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
A Payroll Tax Increase Cools Spending, step by step
- 1
Below potential when the tax rises
The economy starts with AD crossing SRAS to the left of LRAS, so real GDP is below the full-employment level of output. The tax increase is aimed at the trust fund, not at the business cycle, which is what makes its effect on output worth tracing.
- 2
Take-home pay falls, AD shifts left
The tax comes out of gross pay automatically, so disposable income and consumption (C) fall at every price level, shifting AD left. Households absorb part of the tax increase by saving less rather than spending less, so only the MPC share of it comes out of consumption in the first round. That is why the tax multiplier, -MPC/(1 - MPC), is smaller in absolute value than the spending multiplier, 1/(1 - MPC): a tax increase has to be larger than a spending cut to pull AD the same distance. SRAS does not move, because this is the employee side of the tax.
- 3
Prices fall, output slips further
AD crosses the unchanged SRAS at a lower price level and a lower real GDP. Real GDP falls further below the full-employment level marked by LRAS, so the recessionary gap widens and unemployment rises further above its natural rate. Nothing shifted SRAS: the fall in output is the economy sliding down along an unchanged short-run aggregate supply curve.
- 4
Beyond what the graph shows
The graph stops at the short-run result. Payroll taxes fund transfer programs, so if the revenue is paid straight back out as benefits it would raise disposable income again and push AD the other way. Had the tax landed on employers instead, it would have raised per-unit labor costs and shifted SRAS left too. This question holds both of those aside.
Where it ends up
Higher taxes cut disposable income and consumption, so AD shifts left and both the price level and real GDP fall. A tax increase levied for reasons outside the business cycle still contracts output and employment.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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