Debate on the overhauling tax system

A group of big-business CEOs is rolling out some ideas which could shape the coming debate on the overhauling tax system.

The Business Roundtable suggests in a news paper that it’s time to consider shifting the focus of U.S. business-tax policy away from targeted subsidies which plan to boost investment in plant and equipment. Rather, the U.S. must consider lowering overall corporate tax rates in order to attract all the sorts of new investment and profits, the BRT recommends in comments to the House Ways and Means Committee.

Question:

a) In this part you are to elucidate exactly how lowering the effective tax rate on capital (τ) will work (in theory) its way via the economy in order to "attract all sorts of new investment and profits." In this discussion, you require to differentiate among the short- run and long-run. In the space below, elucidate, with graphical analysis, how lowering the effective tax rate on capital will persuade real economic variables in the short run (hint, it’s a demand side story). Draw 4 diagrams (label them 1 through 4), with 1) a user cost; desired capital (K*) diagram, followed through 2) a closed economy desired saving; desired investment diagram, followed through 3) an IS – LM diagram followed through 4) an aggregate supply; aggregate demand diagram.

Begin at an initial equilibrium and label as point A in all diagrams, with all the associated market clearing variables represented by subscript A.  For illustration, in your IS – LM diagram, the interest rate which clears the goods and money market is labeled as rA with the associated output at YA. Note that YA, our initial equilibrium output, is beneath full employment output = YB (we are in a recession, read on).  Now let the effective tax rate on capital fall (similar as a fall in τ) and exhibit how all your graphs are affected.  In specific, locate point B as the new short-run equilibrium in all graphs (suppose the standard; that is, let output rise to YB = full employment Y) while holding the general price level fixed at PA = PB. Make sure you refer to each and every diagram individually describing how and why we get to point B (that is, provide intuitive economic reasoning starting with how a lower τ effects K* and why)!).

b) Now we are going to focus on the idea which in the longer run, the influence of the decrease in the effective tax rate on capital will have ‘supply-side’ effects.  In specific, argue that this new investment, spurred on by the lower effective tax rate on capital, will outcome in a positive productivity shock resulting in a higher “A and K" who will outcome in a shift upward in the production function (through increasing the MPKf and MPN!) In the space beneath draw a production function with the labor market diagram below it and illustrate what is going on in this longer run. That is, locate the corresponding point B (from above), and then show the longer run influence as point C in these two (supply – side) diagrams. What happens to N* and w*=W/P? Explain in detail. Are such results in the labor market consistent with the business cycle facts?  Now explain why output has changed, give two specific reasons. Note, in this part of the problem, do not worry regarding identifying point A in the labor market diagram and production function diagram as point A doesn’t exist given the supposition that labor markets always clear at full employment (that is, a weakness of the classical model). Be sure to label your graphs completely or points will be taken off.

c) Now show how graphs 1) via 4) are affected by this longer-run development. Note again that we suppose that before such longer run developments take hold, the FE line in graph 3) and the LRAS in graph 4) are set at YB. Now let such longer run developments take hold, that is, such supply side effects, and label this final equilibrium as point C. Again, please make sure you refer to each and every diagram individually describing how and why we get to point C (that is, provide intuitive economic reasoning!).

d) In space below, discuss how new classical economists (hint, island) addressed the business fact which money and output are positively correlated. In this portion, be extremely specific in the model that was developed (tell a story) and relate the suppositions in the model to the empirical fact above. Comprise a completely labeled AS – AD diagram in your answer and be sure to elucidate why output changes, given a change in the money stock. Be sure to elucidate exactly why the firm changes their output, by using the terms: relative shock and aggregate shock. Feel free to utilize the bread making illustration that we employed in class making sure you identify clearly, the asymmetry with regard to the real wage the firm pays and the real wage the worker receives. In the last part of your essay, discuss what recognizes the power of monetary policy (in terms of changing output) in this model, what determines how long the short run is, and whether or not you believe that this model is a solid basis for conducting countercyclical monetary policy. Finish the essay by commenting on the given: This model was developed back in the year of 1960s and 1970s and it is now 2010.  Do you believe the model is more relevant or less relevant nowadays relative to when it was written? Describe.

e) We discussed the 'hey day' of Keynesian economics whenever during the year 1960s, many economists and politicians alike firmly believed in a permanent (structural) trade-off among unemployment and inflation. Thus, it was up to the policy maker to select a point on the Phillips curve (as in a policy menu). Draw a Phillip's curve diagram that is representative of the of the 1960s (the entire decade) with point A representing the conditions in the starting of the decade (use data from 1961), point B representing conditions in the middle of the decade (use data from 1966) and point C representing conditions at the end of decade (use data from 1969). Compare the slope of your constructed Phillips curve among points A and B and among points B and C.  Explain why (exactly) we would anticipate the slope of the Phillips curve from points A to B to be different from B to C. Make sure you give an aggregate supply and aggregate demand diagram which comprises the corresponding points A, B, and C to support your arguments.  There is a lot to discuss here!

f) Edmund Phelps and Milton Friedman argued that there was not a permanent tradeoff among unemployment and inflation. In particular, they believed that in the long run, the Phillips curve was vertical. Describe why they felt that the Phillips curve was vertical in the long run and discuss the policy implications if the Phillips curve is vertical in the long run in the context of the misery index. How is vertical long-run Phillips curve associated to a vertical long-run aggregate supply curve? Are these policy implications consistent with the behavior of central banks across the world including the Federal Reserve?  Finish your answer as to what would happen to the misery index in the long run if a Keynesian ( a 'dove' from the 1960s) was conducting policy which still believed there was a permanent tradeoff among unemployment and inflation even though there was not.

g) Finally, let's pretend you are a diehard Keynesian. Give strong arguments as to why the President must follow your policy prescription (that is, the lower T and higher G approach - the tails question) and not the supply-sider approach (cutting the effective tax rate on capital). Make sure you ‘trash’ the supply-sider approach while supporting that Keynesian position (make Keynes proud!).  Draw and refer to the effective demand curve for labor to support your reply.