Some Govt.

Policies in Taxation and Spending

Policy 1: Taxation Offering Saving Incentives

 Taxes on interest income substantially reduce the future
payoff from current savings.
 No tax or a tax decrease on interest income provide an
incentive for households to save at any interest rate.
 The supply of loanable funds curve shifts to the right.
 The equilibrium interest rate decreases..
 If a tax law encourages greater saving, the result will be
lower interest rate and greater investment.
Figure: Effect of Savings incentives on funds
Interest Supply, S1 S2
Rate

5% 1. Tax incentives for

saving increase the
supply of funds
4%

2. . . . which Demand
reduces the
equilibrium
interest rate . . .

0 $1,200 $1,600 Quantity of Funds

3.. . . and raises the equilibrium

quantity of investable funds.
Policy 2: Taxation Offering Investment
Incentives
 Waiver of investment tax or an investment tax credit
provides incentives to the investors.
 Increases the demand for investment funds.
 Shifts the demand curve to the right.
 Results in a higher interest rate and a greater savings.
 If a tax laws encourages greater investment, the result will
be higher interest rates and greater saving at the higher
interest rate.
 Subsequently, greater savings will reduce interest rate
and the investment amount will increase again
 Figure: Effects of investment incentives on funds
Interest
Rate Supply
1. An investment
tax credit
6% increases the
demand for
5% loanable funds . . .

2. . . . which
raises the D2
equilibrium
interest rate . . . Demand, D1

0 $1,200 $1,400 Quantity of Funds

3. . . . and raises the equilibrium

quantity of investable funds.
Policy 3: Deficit Budgeting in Developing Economy

Deficit budget means that government spending is higher than tax.

It is done by an increase in government spending through a rise in

government spending or through a fall in tax revenue

Wagner’s Law says: Govt. Spending increase largely as economy

grows

This government spending is a part of Aggregate Expenditure

Budget deficit helps to reduce unemployment and promote GDP growth

If government gradually spends more, it helps to increase GDP

towards full employment level.
 AEF
790
AE0
Aggregate Expenditures
(billions of taka) Gap of Tk 50
690
billion yield Tk
200 billion GDP Recessionary
Expenditure
490 Gap of Tk 50 billion

Full
Employment
45°
490 690 790
Real GDP (billions of taka)

Here, A Gap of Tk 50 billion yield Tk 200 billion GDP (multiplier

is 4), which cannot be supplied in a year.
A part of Recessionary expenditures gap can be supported by
government higher expenditure from deficit budgeting
Policy 4: Budget Deficit without crowding out
 Government budget deficit reduces the supply of funds
available to finance investment for in-country investors.
 A budget deficit decreases the supply of loanable funds.
 The supply curve shifts to the left.
 Increases the equilibrium interest rate.
 Reduces the quantity of investable funds for the home investors
 When government reduces national saving by running a
deficit, the interest rate rises and investment falls
 This reduces the investment called as crowding out.
 Private borrowers who are trying to get finance for investments
started to crowd out for the shortage of fund.
 Need a balance? Needs a government to move for foreign funds?
 Figure: Effect of a Government Budget Deficit
Interest S2
Rate Supply, S1

6% 1. A budget deficit
decreases the
5% supply of funds

2. . . . which
raises the
equilibrium Demand
interest rate . . .

0 $800 $1,200 Quantity of Funds

3. . . . and reduces the equilibrium

quantity of funds.
 Policy 5: Progressive tax system
 Progressive taxes reflect the view that who are able to
pay more should carry a heavier tax burden
 It acts as a stabilizing force in periods of inflation or
recession because the amount of tax increase rate is
more than the changed proportionately of income.
 Progressive Tax system benefits as it:
 Does not even affect the people who live in poverty line .
 Encourages small businesses that would expand the
economy
 Can collect more from wealthy people, a consumption-only tax
system in some cases is not effective because the rich
consume a smaller fraction of their income.
 Policy 6: Optimal Tariff through Free Trade
 Free trade does not necessarily a trade situation without
tariff. It allows a tariff rate that does not restrict the
movements of products among countries
 It is customary to think that tariff is paid by the importer but
is then passed to the consumer as a price increase.
 Optimum tariff system may constitute of:

 A tariff rate that will not block the import and allows free trade.
 A tariff rate maximizes national welfare by keeping a flow of
government revenue from tariff.
 A tariff rate that will also minimize the social or deadweight loss.
 A tariff rate less than the rate that prohibit imports, would
increase the flow of goods from outside world.
 Then, more trade helps to use the comparative advantage of
each country and increases the friendship among countries.