CFA Level 1 - Economics Session 6 - Reading 26: Fiscal Policy-LOS a

CFA Level 1 - Economics Session 6 - Reading 26: Fiscal Policy-LOS a (Notes, Practice Questions, Sample Questions) 1. Michael Vincent and Elizabeth Matthews, economists at Macro Associates, conduct research into the effects of fiscal policy on the economy. Vincent states that government taxing decisions affect the supply of labor. Matthews contends that government taxing decisions affect potential GDP. Regarding their statements, Vincent and Matthews are: Vincent Matthews A) Correct Incorrect B) Correct Correct C) Incorrect Correct Explanation — Fiscal policy refers to the federal government’s decisions regarding government spending and taxing. Income tax increases cause after-tax wages to fall, dampening the incentive to work. Consequently, workers will be less likely to work the same number of hours as they did when their after-tax wages per hour were higher. As income taxes increase, the full-employment supply of labor (a key factor of production) decreases, which causes potential GDP to decrease. Therefore, government taxing decisions affect both the supply of labor and potential GDP 2. Edmund Jones, an economist, recommends that the federal government consider reducing its budget deficit during a recession by raising income taxes with no other fiscal policy changes. Jones’ income tax increase recommendation will most likely have the following effects on the supply of labor and on potential GDP? Supply of labor Potential GDP A) Increase Decrease B) Decrease Decrease C) Decrease Increase Explanation — Taxes dampen the incentive to work. An increase in income taxes causes after-tax wages per hour to fall. Consequently, workers will be less likely to work the same number of hours as they did when their after-tax wages per hour were higher. As income taxes rise, the full-employment supply of labor (a key factor of production) falls, which then causes the potential GDP (intersection of the supply and demand for labor curves) to fall 3. When potential real GDP is less than actual real GDP, the economy is most likely experiencing: A) inflation. B) recession. C) underemployment. Explanation — The economy is in an inflationary phase if actual real GDP is greater than potential real GDP. When actual real GDP equals potential real GDP, the economy is said to be at full employment. The economy is in a recessionary phase if real GDP is less than potential GDP 4. Which of the following statements about the Laffer curve is most accurate? A) There is a tax rate above which further tax rate increases will decrease tax revenue. B) As tax rates decrease, tax revenues decrease at a constant rate. C) As tax rates increase, tax revenues increase with a multiplier effect Explanation — The Laffer curve represents the relation between tax revenues and tax rates. The curve shows that initially, as tax rates increase, tax revenues increase at a decreasing rate. At some tax rate, revenues reach a maximum and any further increase in the tax rate will reduce tax revenues. At higher rates, workers have less incentive to work and the decrease in labor supplied outweighs the effects of the increase in the tax rate 5. The Laffer curve begins at: A) minimum tax revenues and ends at maximum theoretical tax revenues. B) zero tax revenues and ends at zero tax revenues. C) zero tax revenues and ends at maximum theoretical tax revenues Explanation — The Laffer curve begins at zero tax revenues (the tax rate is 0%, so no matter how much labor is supplied, the tax revenue is zero) and ends at zero tax revenues (the tax rate is 100%, so no labor will be supplied, and no tax revenue collected) 6. The idea behind the Laffer curve is that increases in tax rates do not increase tax revenues proportionately because they decrease the: A) supply of labor. B) demand for labor. C) productivity of labor. Explanation — The Laffer curve is based on the concept that income tax rates affect potential GDP because of their influence on the supply of labor. Hence, the name "supply-side" economics 7. The Laffer curve indicates that: A) an increase in income tax rates will increase tax revenue. B) a decrease in sales tax rates could increase tax revenue. C) an increase in income tax rates may not increase tax revenue. Explanation — The Laffer curve suggests that an increase in income tax rates will increase tax revenues up to a point, and thereafter increases in income tax rates will actually decrease tax revenues. Conversely, a decrease in income tax rates may decrease or increase overall tax revenues, depending upon the initial level of income tax rates