I have a direct tax transfer question and want to know the process.?

Question

Suppose the government decides to increase taxes by $20B in order to increase Social Security benefits by the same amount. How will this combined tax-transfer policy affect aggregate demand at current prices?

Answer 1

This is a tricky quesiton. Ideally, assuming there are no transaction costs and that each group (the tax payers and the senior citizens) have the same savings rate, there should be no change in aggregate demand. You are just changing the actors who are actually doing the spending.

If we assume that the recipients of the transfer payment are more likely to spend it than the ones it was taken from, short-term demand is likely to increase, and there is an overall shift from savings to spending. This isn't a bad assumption, given that the taxpayers are probably more affluent than the recipients, and save more of their income.

In reality, things get more complex. The activity of extracting taxes out of people is not costless, and neither is the process of getting the money to the recipients. The savings rates for high income households who would pay the tax is probably different than the recipients of the benefit. Also, we would have to understand the long term effects of shifting the funds from savings and investment to short term consumption.

Taken together, the change would probably not be dramatic on the economy in the short term. The increased spending rate of the recipients would offset the transactions cost. In the long term, the lower savings rate would lower investment, causing a drag on the economy.

Sorry I didn't give you a simple answer, but it's not a simple question. Depending on the level of complexity you want to go into and the assumptions you make, the answer changes a lot.