Effects of Raising Taxes on Budget Balance & Labor Supply

Abstract

Many developing countries are currently running large budget deficits, and most of these countries also confront significant national debt. As a consequence, many are now trying to restore fiscal discipline after providing generous entitlements, state pensions, and other government benefits for many years. Although tax rates have increased in recent decades in most advanced industrial countries, the resulting increase in government revenues has been greatly outpaced by the increase in government expenditures. Many countries must now cut spending, raise taxes, or do both. (Padovano, 2001) The structure and financing of a tax change are critical to achieving economic growth. Tax rate cuts could encourage people to work, save, and invest , however if the tax cuts don't seem to be supported by immediate spending cuts they will likely also result in an increased federal budget deficit, which in the long-term will reduce national saving and increase interest rates. The net impact on growth is uncertain, however several estimates suggest it's either little or negative. Base-broadening measures will eliminate the effect of tax rate cuts on budget deficits, however at the same time they also decrease the impact on labor supply, saving, and investment and so decrease the direct impact on growth. However, they additionally reallocate resources across sectors toward their highest-value economic use, led to high efficiency and potentially increase the size of economy. The results recommend that not all tax changes can have similar impact on growth. Reforms that improve incentives, decrease existing subsidies, avoid deficit financing can have additional positive effects on the long-term size of the economy, but may also create trade-offs between equity and efficiency. (Romer, 2010) In this thesis, I intend to explore what would occur if these countries attempted to balance its budget simply by raising its taxes. I also seek to determine what would occur if each of those countries decided to balance its budgets by using tax increases to accomplish half of the budget fix and by cutting government spending to do the rest. Can these countries succeed in balancing their budgets? If so, what would be the economic costs in terms of total output and labor supply? To pursue this investigation, I will explain how changes in tax rates affect how much people work. (Galí, 2007)