Before the Great Depression, policymakers felt that governments did not need to take any economic action when the economy was not performing as expected. However, after seeing the worldwide impact of the Great Depression, policymakers realized that government intervention in the form of taxation was necessary to stabilize the economy.
There are two economic theories. Laissez-faire was used before the Great Depression. According to Burton et al., laissez-faire suggests that "government should pursue a hands-off policy." The economic theory that governments use now is Keynes' theory. John Maynard Keynes suggested that when the economy was disturbed from its full employment state, the economy would be overwhelmed by a variety of forces and would not be able to correct itself. As a result, governments would have to intervene through the introduction of new tax policies.
According to CSI Global Education, there are some limitations to fiscal policy's effectiveness. First of all, it takes time to get approval for tax legislation. Secondly, it takes time for the tax policies to affect the economy after they have been implemented.
Effects of Taxes on Individuals
When the government changes its taxation policies, it changes the spending power of individuals. If taxes are increased, then workers take home less pay. This means that they will spend less. When people decide to spend less, corporations do not make as much profit and corporations start to cut back on their business operations. As individuals see these corporate cutbacks, they spend even less and the economy starts to decline. However, if the government lowers taxes, then workers' take-home pay is increased, which encourages them to spend. When individuals start spending, corporations earn more profits and have money to expand. This causes corporations to hire more people, and results in increased confidence that the economy will continue to grow. With increased confidence, people continue to spend and this fuels economic growth.
Effects of Taxes on Businesses
Changes in taxation policy also affect businesses. When the government increases taxes on corporations, businesses make less profit. As a result, businesses start to cut back on their expansion projects and start to lay off workers. When people see this, they start worrying about having a job and start to spend less. Since there is decreased spending by businesses and individuals, the economy starts to slow down. However, when governments reduce taxes on corporations, this encourages businesses to expand. As businesses expand, they hire more people and this encourages individuals to spend as they believe they will receive pay increases and do not need to worry about job security. The increased spending by businesses and individuals fuels economic growth.
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