How Do Income Taxes Affect a Business Cycle?

So what keeps the business cycle in check from crashing or over-inflating? Fiscal policies help to control the effect of taxes on the business cycle. During most pre-election campaigns, you'll hear politicians reference fiscal spending or cutting. This is typically to inform the voters of how they pan on helping the average American to live with inflation or depression, depending on the state of the economy at the time.

When a politician releases information on their proposed tax reforms, it's a good thing to pay attention to.

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The business cycle is the fluctuation in the state of the overall economy over long periods of time, such as several months or years. Economies often experience periods of economic expansion, called booms, followed by periods of slow growth, called busts, which create a wave-like, cyclical pattern over time.

During busts or recessions, the gross domestic product tends to be low or in decline while unemployment tends be high. But during booms, economic growth is high, and unemployment is low.

Income taxes are generally considered to have a detrimental impact on economic activity. Consumer spending is an important ingredient for economic growth because when consumers purchase goods, businesses have more revenue to spend on expansion. Business expansion leads to more jobs and more production, which equates to economic growth.

If consumers have to give a large portion of their income to the government, they cannot spend that income on goods and services to fuel economic growth. High taxes can make bust periods of the business cycle more severe and slow growth rates during boom periods. Low taxes can ease the severity of economic busts and drive faster growth during economic booms.

Fiscal policy describes changes that the government makes with regard to spending or taxation in an effort to influence the state of the economy. Government officials can cut income taxes during periods of economic hardship to allow workers to keep more money in the hopes of sparking spending and economic growth.

Similarly, the government can increase income taxes during economic booms to try to keep growth under control and pay off debts incurred during periods of low taxation and high spending. In essence, changes in income taxes can allow the government to reduce the magnitude of economic fluctuations in an attempt to achieve a steady rate of growth.

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Consumers must be both willing and able to spend money to help drive economic growth. Sometimes, even if income tax rates are low and consumers have a substantial amount of disposable income, economic growth might be slow if consumers are worried about the future and decide to save most of their money instead of spending it.