LOS 26e Explain the limitations of discretionary fiscal policy and differentiate between discretionary fiscal policy and automatic stabilizers

Discretionary fiscal policy is not an exact science. First, economic forecasts might be wrong, leading to incorrect policy decisions. Second, complications arise in practice that

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^-p 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-j. (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 because the quantity of labor supplied at full employment has decreased.

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^-p 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-j. (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 because the quantity 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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