Answer to Question #76498 in Macroeconomics for Scout Broughton

Question

What are the main disadvantages of an increase in income tax, assuming the economy has an output gap?

Answer 1

An income tax is a rate charged on the total income or earning of the individual as well as business on their net profit. The main disadvantages of an increase in income tax, assuming the economy has an output gap are:
• Taxation, especially when on higher side, has the tendency of reducing the disposable income of an individual which subsequently reduce the purchasing power as well as saving ability. Lower consumer spending tends to decrease business revenue, which can put negative pressure on hiring and investment.
• For an individual, if income tax increases progressively, it reduces the incentive to work harder and be productive the higher you move up the ladder. Income tax discourages working more and incentivizes working less at the same time. Thus the government's overall desire to maintain steady employment level, and a growing economy is hampered.
• When an economy is in a recession, i.e. during negative economy output gap, if tax is increased, it worsens the situation by increasing unemployment high inflationary gap will form. In order to eliminate this inflationary gap a government needs to reduce tax. This will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest.