Any economy experiences business cycles c characterized by booms and depressions. Economic booms are periods when the economy is growing at a high rate while recessions refer to periods when the economy is experiencing negative growth.
The government’s responsibility is to smoothen the economic cycle as much as possible to offer a stable economic environment for businesses to thrive in. There are two main ways through which an economy facing a recession can be revived. First is through the application of fiscal policies while second is through monetary policies. Tax cuts fall under the monetary policies.
Generally, fiscal policies can be expansionary or contractionary. Expansionary fiscal policies entail either expanding government expenditure aimed at stimulating demand or exercising tax cuts. Notably, taxes are imposed by the government either on incomes or on different economic activities. They effectively reduce the purchasing power of households directly by reducing their disposable incomes or indirectly y making goods and services more expensive.
This being the case, the imposition of taxes reduces aggregate demand in the economy. Aggregate demand refers to the total sum of goods and services demanded by all the economic agents in the economy. The agents include households, government as well as firms (Fiscal Policy: Taxes and Government Spending, 2010, par3).
Tax cuts thus help stimulate or revive the economy in the sense that they boost the real incomes for households. An increase in real income stimulates demand due to the increased purchasing power among households. Since households form a significant part of aggregate demand, the level of aggregate demand in the economy is increased. An increase in aggregate demand offers an incentive for producers to produce more to meet the increased demand; hence, economic activities are revived.
With increased production, demand for workers goes up; thus the high unemployment levels which characterize an economy in a recession are reduced. The measure to which a tax reduction or a tax increment affects the aggregate demand is called the tax multiplier. It explains the effect of a change in tax in consideration of other economic factors such as the marginal propensity to consume. This is because some of the money freed up by the tax cut does not end up being spent but rather may be saved or invested (Tax Multiplier, 2010, par4).
It should, however, be noted that tax cuts may reduce government revenues though this depends on how the taxpayers react. In the short run, revenues may be reduced, but as demand goes up, higher volumes of transactions may compensate for the reduction. Notably, lower government revenues mean that the government is less able to fund many projects hence a reduction in demand.
This may result in a phenomenon called the crowding out effect. However, in most cases, tax cuts will yield to positive aggregate demand. Most government use tax cuts together with expansions in government expenditures in a bid to maximize the effect on the economy by avoiding this crowding out elements as well as accelerating the rate at which the economy is revived (Fiscal Policy: Taxes and Government Spending, 2010, par5).
As has been explained, tax cuts are an important part of employing stimulus policies to revive the economy. The most important element is that unlike expansions in government expenditure which stimulate the economy through demand created by the government itself, tax cuts stimulate the economy through demand generated from the household level and is thus more appreciated.
Fiscal Policy: Taxes and Government Spending. (2010). Spark notes. Web.
Tax Multiplier. (2010). Amosweb. Web.