Governments impose taxes on a variety economic transactions — including income earned from sources such as salaries, wages, self-employment, interest and dividends — to raise funds to continue their operations. Income taxation provides governments with a vital source of revenue, but it can potentially have a detrimental impact on economic growth because it tends to reduce the demand for goods and services in the economy. Aggregate demand is a term commonly used in economics, which refers to the total demand for goods and services in an economy.
Aggregate Demand Determines Growth Rate of Economy
Aggregate demand is an important factor in determining the growth rate of an economy: when people demand more goods and services, businesses make more revenue and are more likely to expand and hire more workers, leading to economic growth. When aggregate demand is low, businesses tend to make less money and may lay off workers or downsize in an effort to cut costs, leading to a slowing of economic growth or economic contraction.
Income Taxes and Demand
When people have less disposable income to spend on goods and services, it leads to lower aggregate demand. Since income taxes take money away from consumers, they tend to decrease aggregate demand. For instance, you had to pay 10 percent more in income taxes this year than you did last year, but your total income stayed the same, you have less money left over to spend on things like entertainment, clothes, eating out and travel.
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Governments commonly employ tax cuts as a means of increasing consumer demand and sparking economic activity. For example, during the late 2000s the U.S. government introduced a variety of tax incentives such as tax credits on new homes and vehicles in an attempt to increase demand and economic growth.
Changes in income can have different impacts on the demand for goods. People tend to buy certain goods they consider to be necessities regardless of income. For example, you might not buy significantly less milk or gasoline even if you have less money to spend each month due to higher taxes. On the other hand, consumers may be more willing to cut luxuries like expensive vacations, eating at fancy restaurants and buying designer clothes out of their budgets. In other words, higher income taxes may hurt businesses that sell non-essential goods and services more than others.