Can Tax Cuts avoid a recession?

About £77 billion was wiped from the value of leading FTSE 100 companies over fears of a US recession. The FTSE 100 index is now down to its lowest level in 19 months.

In particular, stock markets were unimpressed by President Bush’s plan for tax cuts. In American politics tax cuts are often seen as the ‘solution’ to many economic ills. Reagan, Bush and many other politicians have hoped tax cuts both increases labour productivity and boosts demand. Some have even gone so far as to suggest that tax cuts pay for themselves. (people are so happy to have lower taxes they work many more hours ending up paying more tax)

Alas tax cuts may not increase Supply and they may have little impact on demand – it depends on when and how they are cut. See also: Can UK and US avoid recession

What is the impact of a cut in Income Tax on the labour Market?

  • A cut in income tax makes work more attractive. Therefore, the substitution effect says people will work more. This is because work is relatively more attractive than leisure,
  • However, the Income effect suggests people may not work longer hours and increase supply of labour. This is because the income effect of a tax cut means people can get a certain income through working less hours.
  • Therefore there are 2 conflicting effects of a tax cut and it is uncertain whether supply of labour will increase. It depends what the tax rate was to start with.
  • E.g. if income tax was 70% a cut in tax may increase supply of labour.
  • Lower income tax increases disposable income, therefore, it may encourage people to spend more. There may be an increase in the aggregate demand for labour.
  • However, it depends on marginal propensity to consume. e.g. if people save, buy imports or pay taxes then consumption doesn’t increase. For example, in a recession a cut in tax may lead to increased savings. People are not keen to spend more.

2 thoughts on “Can Tax Cuts avoid a recession?

  1. Surely a tax cut provides more disposable income which will find its way back in to the economy,i find the reference to less hours worked and no INCREASE in productivity a little misleading as the majority of the working population work fixed hours and do not have the option of reducing ones hours of work.

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