This paper investigates the economic and policy implications of tax indexation by developing a model to assess the impact that various tax indexation schemes play in influencing the graphical slope or the price-level elasticity of aggregate demand. More specifically, the purpose of this paper is to demonstrate how income-based tax indexation impacts the price-level elasticity of aggregate demand and fiscal and monetary policy effectiveness within the context of an AS/AD ISLM core macroeconomic model.
II. DATA/METHODS
The model is a standard price-flexible ISLM closed economy model. Real saving is a function of real disposable income and the real value of aggregate assets, with nominal financial assets constituting the sum of narrowly defined money and consol bonds. Real investment is specified as a function of the real rate of interest. In addition, the tax revenue is specified as a variable proportion of real income. The money market consists of real money demand which is stated as a function of real income and the interest rate. The supply of money equation is influenced only by the discretion of the central bank. A general equilibrium expression is obtained from the above, which includes the tax indexation parameter, allowing the influence of tax indexation on policy effectiveness to be discussed.
III. RESULTS/EXPECTED RESULTS
The structural equations for the product and money markets are solved simultaneously to arrive at expressions for the slope and the price-level elasticity of aggregate demand. It is shown that the value of the price-level elasticity is affected by a number of underlying structural parameters from the product and money markets. Specifically, by considering various tax indexation schemes, it is shown that in an environment where the price level and nominal income rise at the same rate, the absence of real-income indexed tax rates results in taxpayers being shifted into a higher marginal tax rate range, leading to an overall reduction in aggregate consumption. Conversely, if the tax system and corresponding taxable income is indexed to changes in real income, then consumption is unaffected. Therefore, it is shown that a real-income indexed tax scheme should, ceteris paribus, lead to a reduction in the price-level elasticity of aggregate demand.
Alternate JEL Category E60