II. Supply-Side Effects of Fiscal Policy

The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects.

The Effects of Taxes on Full Employment and Potential GDP

• The labor market determines the full employment quantity of labor, which, together with the production function, determine potential GDP.
• The equilibrium quantity of employment is determined in the labor market. The first figure shows the labor market. In the figure equilibrium employment is 250 billion hours per year. This amount of employment is full-employment.
• The second figure shows the production function. With employment of 250 billion hours, the production function shows that real GDP is $13 trillion.
• An income tax decreases the supply of labor and shifts the supply of labor curve leftward. In the top figure, the LS curve shifts leftward. Because of the tax wedge, the level of employment decreases. In the bottom figure the decrease in employment decreases potential GDP.
• An income tax drives a tax wedge between the before-tax wage rate that firms pay and the after-tax wage rate that workers receive. Other taxes, such as sales taxes, add to the tax wedge by effectively lowering the real wage rate.

Some Real World Tax Wedges … Does the Tax Wedge Matter?

Tax wedges vary across countries, being much higher in France than in the United States. According to supply-side economists such as Ed Prescott, the tax wedge has a large impact on potential GDP. Potential GDP per person in France is 14 percent below that in the United States and Prescott asserts that the entire difference can be attributed to the difference in the countries’ tax wedges.

Taxes and the Incentive to Save and Invest

• A tax on interest income decreases the supply of saving and shifts the supply of loanable funds curve leftward. The tax drives a wedge between the after-tax interest rate received by savers and the interest rate paid by firms. The tax does not change the demand for loanable funds. The figure shows the result: the real interest rate paid by borrowers rises (from 5 percent to 6 percent in the figure) and the equilibrium quantity of loanable funds and investment decrease.
• The decrease in investment lowers the growth rate of potential GDP.

Tax Revenues and the Laffer Curve

• The relationship between the tax rate and the amount of tax collected is called the Laffer curve. The Laffer curve shows that at a high enough tax rate, an increase in tax rates decreases tax revenues. Tax revenues decrease because individuals find ways to avoid the high taxes, including by working less.
• Most economists believe that taxes have an effect on the supply of labor, but that in the U.S. economy, the tax rate is low enough so that an increase in the tax rate increases tax revenues.

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