by Algy Moncrieff

Created on: May 25, 2007   Last Updated: June 04, 2009

The effects of a tax on an economy are wide ranging and will have different effects depending on what sort of tax they are and what position in the economic cycle the economy is in. Therefore, to say that lower taxes will increase a country's economic health is not correct, because lower taxes will only increase a country's economic health under certain conditions.

First, allow me to introduce a few terms. The Mundell-Fleming model of the open economy is a powerful model for assessing the effects of certain factors that influence an economy. This makes a few assumptions:

1. Perfect capital mobility - the economy can borrow or lend as much as it wants on world markets

2. Small economy - the economy is small, which in this case means that its borrowing and lending does not affect the world interest rate, r*

3. Open economy - the economy can trade with the rest of the world, if this is to its advantage.

The Mundell-Fleming model, based on a large amount of research (Mundell won the Nobel Prize in 1999), gives the equation for national income as:

Y = C(Y - T) + I(r*) + G + NX(e)

This says that national income (Y) is equal to consumption (C) which is a function of disposable income (Y - T(tax)), plus investment (I) as a function of the world interest rate (r*), plus government spending (G), plus net exports (NX = X(exports) - M(imports)). Thus, if any one of these factors changes, national income (aka growth), will be affected. Or rather, it will be affected in the short run - in the long run we have only got limited natural resources and technology so Y must be fixed. Therefore an increase in C will mean that prices will have to rise to accommodate the increased demand, and the result will simply be inflation.

The traditional view of a tax cut is that it will stimulate consumer spending, reducing saving, which implies an increase in interest rates and a reduction in investment. Another view though was suggested by David Ricardo - that of Ricardian Equivalence. This is the idea that consumers are forward looking and therefore will base their spending decisions not only on their current income but also on their expectations of future income. A tax cut will therefore be unlikely under this view to increase consumer spending, because consumers will realise that the only way the government will be able to finance the tax cut is by increasing taxes in the future, unless government spending decreases, but then it will be the fall in G not T that stimulates

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