Income Tax Theories - Demand-Side or Supply-Side? - Tax as a policy tool

The government may make changes in income tax for a number of reasons. A Keynesian government may choose to vary the level of tax to try to influence the level of aggregate demand and therefore economic growth. This would be using tax as a demand-side policy.

A Classical government would view the role of tax as an instrument very differently. It would argue that taxation should be as low as possible to create incentives for people to work harder. Low tax should also encourage entrepreneurs as they will not lose much of the profit in taxation. Using tax in this way to encourage enterprise and hard work is a supply-side policy.

In practice, many governments will use taxation in a combination of these two ways and will formulate their policy to fit the prevailing conditions. However, whenever changing income tax in the Virtual Economy, remember that there will be demand-side and supply-side effects. To cut taxes for supply-side reasons only may mean also cutting government expenditure by the same amount. In this way, you increase demand through the tax cut, but then reduce demand from the government expenditure cut.

For more details on Keynesian and Classical policies, you may want to look at the economic theory section of the Virtual Economy.