What Are Effects of Raising Taxes and Decreasing Spending?

Raising taxes while decreasing government spending is a form of fiscal policy known as a contractionary or “tight” fiscal policy. The primary goal is to address economic issues like high inflation, which occurs when the general price level of goods and services rises too quickly. This policy is applied when an economy is considered to be “overheating.”

Another reason for using this policy is to reduce government debt. By increasing taxes and cutting spending, the government directly targets the budget deficit, which occurs when spending exceeds revenues and contributes to the national debt.

Impact on Overall Economic Activity

Higher taxes and reduced government spending directly influence an economy’s aggregate demand, which is the total demand for all finished goods and services. A decrease in government spending is a direct removal of demand from the economy. For instance, canceling a public infrastructure project means less money is being spent on materials and labor, immediately lowering economic activity.

Simultaneously, an increase in taxes reduces the disposable income available to households and the after-tax profits retained by businesses. When individuals have less take-home pay, their spending on goods and services declines. Likewise, when corporations face higher tax liabilities, they have fewer resources for investment. This reduction in both consumption and investment further dampens aggregate demand.

This initial reduction in spending is often magnified by the “multiplier effect.” This economic concept describes how an initial change in spending leads to a larger overall change in economic output. When the government cuts spending, the initial recipients, such as contractors or government employees, have less income. Consequently, they reduce their own spending, which in turn lowers the income of others.

The result of reduced aggregate demand is a slowdown in the rate of economic growth, measured by real Gross Domestic Product (GDP). If the contractionary measures are aggressive or the economy is already weak, this slowdown can increase the risk of a recession. A recession is characterized by a significant decline in economic activity. The policy acts as a brake on the economy, intended to cool it down but with the potential to slow it too much.

Consequences for Prices and Employment

The reduction in aggregate demand has direct consequences for price levels. With less overall demand for goods and services, businesses face increased competition for fewer consumer dollars. This environment creates disinflationary pressure, meaning the rate of inflation slows down. If the policy is potent and demand falls sharply, it can lead to deflation, a period of falling prices that can be harmful.

The impact on employment stems from the business response to falling demand. When companies see their sales decline, they often scale back production to avoid accumulating unsold inventory. A reduction in production levels means less need for labor, leading businesses to slow or freeze hiring. In more severe cases, companies may resort to layoffs to cut costs, causing the unemployment rate to rise.

This outcome highlights a common trade-off in economic policy: the effort to control inflation can lead to higher unemployment. By deliberately slowing the economy to stabilize prices, the policy reduces the demand that supports job creation. The result is a short-term inverse relationship where lower inflation comes at the cost of a weaker labor market. This dynamic is a consideration for policymakers.

Effects on Government Finances

The direct effect of raising taxes and cutting spending is on the government’s budget balance. The policy is designed to improve the government’s fiscal position by increasing revenues and decreasing expenditures. Higher collections from personal income and corporate profit taxes boost revenue, while reductions in government programs, subsidies, and operational costs shrink outlays.

This approach directly addresses a budget deficit, which is the shortfall between spending and revenue in a single year. The intended result is either a smaller deficit or the creation of a budget surplus, where revenues exceed expenditures. This can help slow the growth of the national debt, which is the cumulative total of all past deficits.

A nuance can emerge if the policy’s impact on the broader economy is severe. Should the measures trigger a significant economic slowdown or a recession, the positive effects on the budget can be partially undermined. A weaker economy leads to lower corporate profits and household incomes, which in turn can cause tax revenues to fall below initial projections. This decline in tax receipts can counteract some of the intended deficit reduction.

Influence on Businesses and Households

The policy of raising taxes and cutting spending creates direct financial pressures on households. The impact is felt through a reduction in disposable income. An increase in federal income tax rates, for example, means a smaller paycheck. Higher consumption taxes, such as federal excise taxes on gasoline or tobacco, increase the cost of goods, leaving less money for other purchases, saving, or investing.

For businesses, higher corporate taxes directly reduce after-tax profits. For instance, an increase in the corporate tax rate leaves a company with less cash flow from its net income before taxes. This reduction in retained earnings can make it more difficult to fund research and development, invest in new capital, or expand operations, thereby hindering growth.

The broader economic slowdown resulting from the policy also translates into lower revenues for businesses. As both the government and consumers cut back on their spending, companies across various sectors experience a decline in sales. This pressure, combined with higher taxes, can create a challenging operational environment. Businesses may respond by delaying investments or reducing their workforce to maintain profitability.