Quiz 13: Fiscal Policy


The government debt to GDP ratio has mounted to 100 percent after the recession of 2008 and is not likely to fall in near future. GDP is a measure of repayment ability of the government - the ability to repay the debt mostly done through taxes. If there is a high debt to GDP ratio, it indicates a rising burden and a falling ratio suggests a falling burden. The dollar value of debt never warns against such events. One of the major components of debt is the international debt that amounted to $11.7 trillion as of June 2014. Half of this debt was US government's borrowing. US government pays around 50 percent of the total federal revenue in Social Security, Medicaid and Medicare which is going to explode in the near future.

The credible business plan for the government to adopt is to increase its tax revenue (by increasing taxes) and spend it on those items or public assets that yield higher return in comparison to debt interest.

(a) Supply of labor decreased because an income tax weakens the incentive to work and decreases the supply of labor. The reason is that for each dollar of before tax earnings, workers must pay the government an amount determined by the income tax code. Therefore, workers look at the after tax wage rate when they decide how much labor to supply. (b) In the labor market, the income tax has no effect on the demand for labor. The reason is that, the quantity of labor that firms plan to hire depends only on how productive labor is and what its costs that means its real wage rate. (c) The level of employment decreases due to a decrease in the supply of labour. The supply of labor decreases, as an income tax weakens the incentive to work. As a result, the wage rate increases. (d) The equilibrium before tax wage rate rises due to smaller supply of labor. (e) The equilibrium after tax wage rate falls due to smaller supply of labor as income tax weakens the incentive to work. (f) An imposition of tax decreases potential GDP because the full employment the quantity of labor decreases. Moreover, a decrease in potential GDP decreases the aggregate supply.