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RUNNING HEAD: Final Project

Question 1: What happens to net personal income when the government raises taxes?
When the government lowers taxes?
In general, when the government raises taxes and the gross income stays, that would lead
to a decrease the net personal income. When the government raises taxes, most peoples net
personal income decreases and that means their disposable income will also decrease. Since their
disposable income decreases, they spend less and for sure that would lead to a decreased gross
income. That means that they will have less disposable income and that can lead to a decrease in
total tax revenue as the gross incomes of the population can drop a greater percentage than the
increased percentage of the tax. This is what the classic economic rule tells us about raising
taxes.
The history of Germany tells us that the previous rule is true if the government does not
distinguish between high and low income. So, in Germany, taxes on the wealthy are much higher
than the USA and the distribution of income is more equal (History of US Income Tax, 2014).
The German experienced raising taxes after World War 2 and have showed us that raising taxes
during economic crisis make a lot of sense.
Higher taxes and lower spending toward debt-friendly stimulus. This means further
increasing taxes and raising government expenditure in the same proportion. That way, the
debt/GDP ratio declines because the denominator (economic output) increases, not because the
numerator (the total the government has borrowed) declines. The German tax system is similar to
the structures in other western countries. Citizens in Germany pay income taxes throughout the
year and usually with an employer deducting tax from each paycheck. There are also different
types of taxes in Germany, such as the individual income tax.

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The income tax in Germany is different from one person to another -- or in other words,
the income tax depends on the persons income. When you have a higher income, you pay more
tax. In some circumstances, you do not pay at all. Income taxes in Germany are divided to
different segments (How your Income Tax is Calculated, 2014):

If the income less than 8,130 is tax free for single person (16,260 for a married

couple)
Income up to 52,881 for a single person (105,762 for a married couple) is then

taxed with a rate progressively increasing from 14% to 42%.


Income from 52,882 (105,764) up to 250,730 (501,460) is taxed at 42%.
Amounts over those are taxed at 45%.

Question 2: How is GDP affected by higher taxes? Lower taxes?


It still very controversial what is the better to increase taxes or cut taxes. In the classic
economic theory, reducing taxes would increase the disposable income and increase the
expenditure. Its exactly the opposite results when the government raises taxes and that would
increase the net personal income. A lot of economists see that lowering the income tax would not
help the economy and would not increase the personal income. Small business owners have the
highest advantage of a lower the income tax.
The issue with small businesses is that most small businesses owners take advantage of
provisions that allow them to pay personal income taxes on their profits rather than corporate
taxes. Cutting income taxes is a poor strategy for encouraging small business growth and job
creation. On the other hand, decreasing income tax would require a big chance from the
government to invest the extra tax money in different sectors, such as the education and health.
Some countries have experienced negative results from lowering income taxes. This is
what happened to the USA in 1964 when congress cut 18% from income taxes to take the

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country out of recession (Reflection of the Revenue Act of 1964, 2014). Although they did
this, the results were not good and other countries. An example would be when Ireland had tax
cuts which are believed to have improved living standards significantly. For years, the Irish were
faced with high unemployment, and high taxes. In 1986, Ireland faced a fiscal crisis. After
reducing government spending, the government lowered taxes on both individuals and
corporations. Over the next 13 years, Ireland's per capita income went from only 63% of the
United Kingdom's average.
There is a strong and complicated relationship between GDP and tax system and the conflict
between economists still exist about this relationship
1- When the government lowers income tax, this will motivate people to work more since
they will earn more and they will spend less for taxes and that will lead us to growth the
GDP.
2- When the government raises income taxes people will chose to work less since there is a
big part from their income going to the government and as result the GDP will goes
down.
GDP, or Gross Domestic Product, is the sum of all goods products and services provided in a
country during one year. These measurements are extremely important and the economies of
these countries follow basic rules that are accepted worldwide. The German economy is
extremely strong the fourth strongest in the world. This means that their goods and services
surpass 189 other countries in the world with a population of a little over 80.2 million. With this,
there are different situations that can occur if taxes are raised or lowered in regards to GDP.

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Figure 1: GDP Growth Rate of Germany


Source: Tradingeconomics.com
With regards to basic economy standards, if the German government decided to raise taxes,
the GDP should naturally decrease GDP. The only reason that taxes would increase would
mainly be if the government needed money. In situations like World War 2, the government
would be required to increase taxes in order to raise money and stabilize government spending.
As quoted in some research findings: Tax changes have very large effects: an exogenous tax
increase of 1 percent of GDP lowers real GDP by roughly 2 to 3 percent." This means that with
tax increases, it will show that the total production of goods and services in the country will
decrease.
If we change this scenario and actually lower taxes, it is shown that GDP has, as may be
obvious, the opposite effect. In the situation of lowering German citizen taxes, the GDP at the
end of the year after calculation should show that it increases. The reasoning behind this is
simple: if the taxes are lowered, a tax paying citizen would end up having more income left to
themselves. This means that a demand for more goods would be shown, and thus, a larger GDP.
Citizens are consumers and through different economic research, the more money in the hands of

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citizens, the more goods will be purchased. If taxes are lowered within Germany, more
investment would be encouraged as well as purchasing.

Figure 2: Change in Personal Income tax rate of Germany


Source: Trading economics.com
We can see in Figure 1 and 2 what kind of changes these have had with Germany in the
last 10 years. Personal income tax and sales tax can be shown to be at different levels and we
also have a figure 1 of GDP of Germany (German GDP Growth rate, n.d.). This can give a
clear image regarding what actually has happened. All are shown from the year 2000 through
current 2014.
As you can see, the chart is fairly the same as what economic rules would suggest. The
only exception is when the crash of 2009 occurred and the world experienced a huge shakeup
with the financial industry. The best way to take a look at the graphs for Germanys economy is
to look at 2004 through 2007. You can clearly see that when the personal income tax rate started
to decrease in 2003, that the GDP started to increase until a bit into 2008 when the world
financial crisis first began. This easily shows that GDP can grow if the government lowers the
tax. In the end, this will encourage more trade and manufacturing within the country.

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Question 3: What other economic factors are affected when taxes are raised or lowered,
and how are they affected?
Taxes are a part of our daily life. Everything we purchase, w e have to pay sales taxes.
In USA, the taxes are calculated after the item is purchased, and added on sales prices. Most of
the countries have set sales prices that sale taxes are already calculated and added on the sale
price. Either way we have to pay taxes every little thing we purchase.
Governments have the power to raise and decrease the tax rates. It's very important
decision for government to increase or decrease the tax rates since the tax rates are very crucial
decisions for the economy.
The first impact of the raising or decreasing the tax rates is the personal income.
Personal income decrease when the tax rates are increase, it increases when the tax rates are
decrease. It is directly related to personal income. When the government raises the tax rates,
consumers will pay more than what they usually pay, therefore it will cause a decrease in their
personal income. It is opposites when the government decreases the tax rates, consumer will
pay less, and it will cause an increase in their personal income (Andrianacos, D., & Akarca, A.
T., 1998).
Economist also forecast a increases in tax rates will cause reduce in GDP, since the
GDP is directly related to personal income. Researches show that 1 % increase in tax rates will
cause 1 % decrease in GDP after 18 months (Kriz, K.A., 2001).
Tax arrangement is one of the economic tools that government uses to control the
economy. They usually do the tax arrangements w h e n there are budget deficit. Government
increases the tax rates to increase their tax revenues in order to cover the budget deficit. The
other way to cover budget deficit is to decrease government spending. Reducing the

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government spending is more efficient in short run than increasing the tax rates. The economist
thinks that increasing the tax rates might cause serious damages in long run. Increasing the tax
rates will hurt the economy by reducing the demand. Less money will be spent in the economy.
On the other hand, while increasing the tax rates lead consumers spend less, it will actually
lead increase in government spending. The government will do more spending in areas such
as education, roads, building, social securities, Medicare, national securities, etc. Citizens will
receive better services from the government, but they will be more likely to spend less. This
kind of government spending will receive high social returns in long term.
In Germany, the income rate has been reduced from 25 % to 15 %. Trade tax is no
longer a tax deductible expense. After the global financial crisis, which started in USA in
2007, and has spread out to other countries by financial markets, there have been some tax
arrangements by the German government to overcome this financial crisis. They reduced the
personal income taxes and vehicle taxes in 2009, but the German government was very
sensitive about the government budget, and to balance the budget, they also increase some of
the excise. They reduced the mortgage rate in short run, and they made the medical insurance
available for citizens to deduct from their personal income taxes which helped a lot.
Question 4: Should the government increase tax rates on everyone as a way to equalize
incomes and wealth?
The Organization for Economic Cooperation and Development (OECD) said that for an
overhaul of the tax system in developed economies to ensure the very rich pay a large share of
their incomes, and help limit or roll back the sharp increase in income inequality that has
occurred over recent decades. Decreasing marginal tax rates for top incomes and tax exemptions
for capital income may result in top income groups accumulating more capital and wealth and

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transmitting this through bequests to younger generations, continually concentrating power and
privilege (Hannon, P., 2014). The best tax system is one that strikes the optimum balance
between economic efficiency and equity; helps in maximizing the overall profit by distorting the
allocation of resources in the least possible way (Gramm, P. & McMillin, S., 2012).
Many industrialized countries have turned their focus to the top income earners. Income
concentration is not desirable for the following reasons (Jenderny, K., 2014),
1. A large share of the citizens around the world has preference for equal income
distribution.
2. Rising income concentration comes along with rising relative deprivation.
3. Strong economic elite might gain concomitant political power that conicts with our
democratic ideal.
4. The share of economic growth that accrues to the richest persons has an impact on
how growth can be interpreted.
OCED has found in its recent survey and studies the various causes of income inequality.
Firstly, one of the key drivers of income inequality is the change in earning inequality. Another
factor that causes income inequality is globalization. Increasing trade integration are associated
with relative high wage for skilled workers and hence contributing for greater income inequality.
The most important and plausible explanation are policy choices and regulations. They can have
a crucial impact. They can shape how globalization and technological changes affect the
distribution of income.
In Germany, the top income mobility has been fairly constant during 2001-2006. Also the
change in income inequality in Germany has been almost constant since 2004. The main reason
for this is because of the Fiscal Equalization System (FES). In Germany all taxes are applied by
federal tax laws and they are harmonized across states. The states are responsible for the
administration and collection of the taxes. The main purpose of the FES is that the redistribution

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of the tax revenue will favor the poor states. The most interesting feature in Germanys tax
system is that there is an explicit redistribution of taxes between states such that rich states pay
transfer to poor states.
The FES proceeds in four stages. They are as discussed below (The Federal Financial
equalization system in Germany, n.d.),
1. First, the entire tax revenue (Income Tax, Corporation Tax and Value Added tax
(VAT)) is distributed to the two levels of government namely the Federation and all
the States (Lnder) and the municipalities receive a supplementary grant of revenue,
which is known as the vertical distribution. Income tax and VAT generate the most
revenue.
2. In the second stage, the total states portion of tax revenue is assigned among the
various states, known as the horizontal distribution.
3. In a third stage, there is equalization between poor state and rich state, known as the
financial equalization among the states.
4. In the last stage, the poor states also receive funds from the Federation known as the
supplementary federal grants.
Due to their taxation policy the ratio between the incomes of those at top and bottom is
one of the lowest in the world being around 6 to 1. US, Turkey and Israel have one of the largest
roughly around 14 to 1. Denmark and Sweden also have a low income gap of around 6 to 1.
Although the income gap in Germany has risen from 5 to 1 to 6 to1 from 1980s. It is because of
these taxation policies that Germany is one of the most fluid economies of the world. The
percentage of the top income in the country has been almost constant as compared to the rest of
the world.