Explain how a reduction in income tax could affect both aggregate demand and aggregate supply in an economy

The graphs I made unfortunately aren't copy/pasting here unfortunately but I can redraw them on the whiteboard. Income tax is a tax levied on consumer income, collected by the government. Aggregate demand is the total quantity of aggregate output (real GDP) that all buyers in an economy want to buy at different possible price levels, ceteris paribus. Aggregate supply is the total quantity of goods and services produced in an economy (real GDP) over a particular time period at different price levels. A reduction in income tax increases consumer disposable income, and depending on the marginal propensity to consume, can lead to an increase in spending on goods and services, thus increasing total consumption in the market. Consumption is a component of the AD and this reduced income tax can cause an outward shift in the AD curve to the right (AD to AD1) and consequently result in an increase in APL from APLe to APL1. A reduction in the income tax incentivises the consumers to work, as the same span of time, yields a higher wage because they are left with a greater proportion of their income. Therefore, the supply of the labour force increases and this causes the supply of the goods and services to increase in the short run. This can also cause a shift in LRAS to the right, depending on the duration that income tax is reduced. If the LRAS does not shift to the right then the economy has reached full capacity, Y*, but the average price levels have remained the same, APLe.

Answered by Mariam H. Economics tutor

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