Economics – Government and the macroeconomy - Supply-side policy | e-Consult

The impact of a reduction in income tax on the aggregate supply (AS) curve can be illustrated using an economic diagram. The policy aims to shift the AS curve to the right, indicating an increase in the potential output of the economy. Here's how:

Diagram Explanation:

• Initial AS Curve: Represents the economy's potential output before the tax cut.
• Shift to the Right: The tax cut increases the incentive to work and invest, leading to an increase in the quantity of goods and services supplied at each price level. This shifts the AS curve to the right.
• New Equilibrium: The new AS curve intersects the demand curve at a higher price level and a higher quantity of output.

Limitations of the Diagram:

• Assumptions: The diagram assumes that the tax cut will lead to a significant increase in labour supply and investment. This may not always be the case.
• Time Lags: The impact of the tax cut may not be immediate. It can take time for people to respond to the incentive to work and invest.
• Demand-Side Factors: The diagram doesn't account for demand-side factors. If demand is weak, the increase in supply may not lead to a significant increase in output. The economy could suffer from a situation of 'oligos' (excess supply).
• Other Factors: The diagram doesn't consider other factors that can affect the AS curve, such as changes in technology, regulations, or global economic conditions.
• Effectiveness depends on elasticity: The extent of the shift in the AS curve depends on the elasticity of labour supply and investment. If these are inelastic, the impact will be smaller.

Therefore, while the AS diagram provides a useful framework for understanding the potential impact of lower direct taxes, it's important to consider the limitations and the broader economic context when evaluating the policy's effectiveness.