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Taxes - to cut or not to cut?
Supplying the demand or demanding the supply?
A big issue among economists is whether or not fiscal policy (taxation and government expenditure) should be used as a tool of economic management. A cut in taxation should help to encourage people to work harder, but will also leave them with more money in their pockets to spend. This should increase the level of aggregate demand in the economy. Similarly, an increase in government
expenditure should help boost the economy. Thus in times of recession the government could cut taxes and increase government spending and help boost the level of demand. This is shown in the diagram below by a shift to the right of the aggregate demand curve.
However, economists differ over whether this is appropriate. Keynesian economists would argue for this sort of intervention (known as demand management), but Classical and New Classical economists would argue that this would de-stabilise the economy and be inflationary. The reasoning behind this is shown in the diagram below.
The increase in aggregate demand shown here will simply cause prices to rise in the long run. Classical economists therefore argue that there is no point in the government directly intervening through fiscal policy to manage the economy as they will simply cause inflation.
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