LOS 26a Explain supplyside effects on employment potential GDP and aggregate supply including the income tax and taxes on expenditure and describe the Laffer curve and its relation to supplyside economics

Supply-side effects refer to the influence that fiscal policy, especially taxation, has on long-run aggregate supply (potential real GDP). Income taxes reduce the incentive to work by creating a tax wedge between pretax and after-tax wages. An increase in income taxes causes after-tax wages to fall. Consequently, workers will be less likely to work the same number of hours as they did when their after-tax wages were higher. As income taxes rise, the full-employment supply of labor (a key factor of production) falls, which reduces potential GDP. These effects are illustrated in Figure 1.

Real

LDP

Production

^—' Function

Q,,

Qv,

i

Figure 1 illustrates the link between tax rates and real GDP. The tax increase causes the labor supply curve to shift to the left, from the before-tax supply curve SBT to after-tax supply curve S^j, which reflects a decrease in after-tax income from an hour's work. This results in a drop in the equilibrium (full-employment) quantity of labor from Lg-(-(labor hours before tax) to LAT (labor hours after tax). Real GDP drops as a result of the decrease in the equilibrium quantity of labor. The production function in Figure 1 shows real GDP (the output of the economy adjusted for price level changes) as a function of labor. Potential real GDP supplied decreases from QCT to O^- because the quantitv of labor supplied at full employment has decreased.

An increase in taxes on consumption expenditures (e.g., sales tax) also causes the supply of labor and potential real GDP to decrease. Workers "convert" hours of work into purchases of goods and services. An increase in expenditure taxes decreases the amount of goods and services that each hour of labor can buy. This disincentive to work reduces the supply of labor, which causes potential GDP to fall.

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