5.6. Effects of Fiscal Policy on Consumer Spending

Lower taxes, everything else being constant, increase households’ disposable income, allowing consumers to increase their spending. The consequences of the cut — how much is spent or saved, and the response of economic activity — depend on the way households make their decisions and on prevailing macroeconomic conditions.

Whether the tax cut is perceived to be temporary or permanent will influence how much consumers save. A temporary cut will alter households’ disposable income relatively little, and so might have little effect on consumption. If the cut is, instead, perceived to be permanent, then households will perceive a larger increase in their disposable income and so will likely increase their desired consumption by much more than they would if they thought the cut were temporary.

There is a potential conflict between the use of fiscal policy to stimulate aggregate demand when the economy is operating below potential in the short run and the use of policy to promote longer-run goals for national saving and capital formation to improve future living standards. When there are underutilized economic resources, fiscal stimulus can increase investment. But when the economy is operating near potential, an increase in the public debt might eventually depress private investment, unless the fiscal stimulus is reversed as the economy approaches full employment and utilisation.

Note: Fiscal drag is a concept where inflation and earnings growth may push more tax payers into higher tax brackets. Therefore fiscal drag has the effect of raising government tax revenue without explicitly raising tax rates.

This fiscal drag has the effect of reducing Aggregate Demand and becomes an example of deflationary fiscal policy. It could also be viewed as an automatic fiscal stabiliser because higher earnings growth will lead to higher tax and therefore moderate inflationary pressure in the economy.