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Economic actor

1). Will consumers always spend the same percentage of any tax cut? Why might they spend more or less than usual? Please explain your answer. A tax cut will have an ambiguous effect on the spending propensity of an individual. If the substitution effect is greater than the income effect, then a tax cut will cause the individual to spend more (relative to the tax cut). If income effect is greater than substitution effect, then a tax cut will cause the individual to spend less. Substitution effect here is the initial reaction of the economic actor.

Income effect refers to a perceived change in income. Suppose a 10% tax cut is implemented. If substitution effect is greater than income effect, then the individual will spend more than 10% of the tax cut. If income effect is greater than substitution effect, then the actor will spend less than 10% of the tax cut. It may be also possible that the level of individual spending (percentage points) remains the same. If a tax cut is implemented, the initial reaction of the individual is to spend more. Depending on the strength of the income effect, the individual may be induced to reduce his spending.

The tax cut may be regarded by the individual as potential savings. Hence, if income effect is greater than substitution effect, then the level of savings increases. In any case, a tax cut will have unambiguous effect on consumer spending. 2) A constitutional amendment has been proposed that would require Congress to balance the budget each year. Is it possible to balance the budget every year? Is it desirable? Please explain your answer by providing the pros and cons of balancing the budget each year. Balancing the budget is not a very difficult task.

There are many ways to reduce deficits/surpluses. The federal government can either reduce or increase taxes. It can also adjust the level of imports relative to exports (this is related to trade adjustments). The federal government can also increase/decrease the floatability of the currency. It can also expand or contract the monetary base of the economy. During the Clinton administration, balanced budget was achieved by adjusting both the optimal federal tax portfolio and the level of imports (relative to exports).

The difficulty rests not so much on the means to balance the federal budget but to the concept of a balanced budget itself. Alexander Hamilton, one of the founding fathers, argued that a balanced budget reduces indiscipline spending in government. Here is partially right. Surplus leads to excessive unnecessary spending (and a general distortion of the economy). However, most economists today see the benefits of deficit spending. Deficit spending removes inefficiencies in the economy by streamlining money and capital markets.

Deficit spending also stimulates increased production in the economy by increasing the flow and availability of credit. During the Reagan administration, the United States reached its potential GDP via deficit spending. 3) Which of the following options do you favor in resolving future social security deficits? What are the advantages and disadvantages of each option? Please explain your answer. (a) Cutting Social Security benefits. The effects of this policy are similar to that of a proportional tax.

It induces the individual to spend and work less (there is an emphasis of decreasing future income – measured by interest imposed on current income). However, the federal government can generate a considerable level of revenue from this policy. (b) Raising payroll taxes. This tax is also distortionary. It reduces incentives to work and creates a void in spending. Individuals are more likely to approve of cutting their benefits than raising payroll taxes. The federal government, however, can raise a large amount of revenue from this policy. (c) Cutting non-Social Security programs. This policy is non-distortionary.

The individual will not be induced to reduce his work time (the individual will concentrate on increasing the value of his future income). This policy only generates a low level of revenue. (d) Raising income taxes. This policy is also non-distortionary. The individual is ‘forced’ to work more to recover the ‘lost’ income. There is also tendency for the individual to decrease his/her level of savings (in a way, it artificially stimulates spending in the economy in the short-run). The amount of revenue collected is almost equal to that in (1). In essence, this is the best of the four options.

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