Fiscal Policy: Increasing Taxes for the Rich to Reduce Budget Deficit and Inequality

Abstract

Fiscal policy initiatives aim to influence the economy through their effect on aggregate demand. This paper evaluates the effect that the proposed high taxation for the rich would have in respect to stated objectives of reducing budget deficit and reducing income inequality. Increased taxation would result into a shift of the AD curve to the left, reducing the amount available for individuals to invest. Since this would increase the government revenue, the government can apply such increased revenue to settle the accumulated debt thus reducing the budget deficit. However, the high debt accumulated so far requires additional measures such as reduction in tax breaks to enable quick recovery from the deficit position. With respect to inequality, the efficacy of the policy would be determined by measures that the government implements to enhance employment. This would be the case since increased taxation would reduce investment thus affecting employment levels in the country.

Introduction

Economic thought concerning the role of government in the economy attracts two opposing viewpoints – the classical and Keynesian propositions. The classical economics, as reinforced by the neoclassical economists, argues for a laissez-faire approach where the government does not intervene in the economy since, in a market driven economy, the markets can self-regulate through the pricing mechanism (Colander, 2008). The Keynesian economics, on the contrary, argues for government intervention to avert a progressive deterioration cycle from which the economy cannot recover through self-regulatory mechanisms (Colander, 2008). The Keynesian point of view arose during the great depression in the 1930s when the output in the economy had declined by almost 30 percent with unemployment levels reaching 25 percent for a period of about 10 years (Colander, 2008, p. 202).

According to the latter view, the government has two options (monetary policy and fiscal policy) that it can use to influence economic outcomes. Monetary policy involves the regulation of the supply of money in the economy, a role carried out through the Federal Reserve (Mankiw, 2002). Fiscal policy involves the alteration of government expenditure and taxation levels to facilitate equilibrium between demand and supply in the economy (Mankiw, 2002). The current paper focuses on fiscal policy by considering the effects of the proposal to increase taxation for the rich as a way to reduce the U.S budget deficit and inequality in society. The paper will discuss how such an approach influences the aggregate demand and aggregate supply in the economy. Firstly, however, a background to the issue and fiscal policy tools available to the government is presented briefly. Go to part two here.

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