The effect of tax cuts on the macro economy will however depend on the way the taxpayers will use their additional income and adjustment of government to its low income.
This is referred to as fiscal policy which contrasts the macroeconomic policy which attempts to control interest rates as well as supply of money in stabilizing the economy. Fiscal policy uses taxation and government expenditure as its two instruments. Changes in taxation levels and government spending impacts on aggregate demand and economic activity level in the economy. It also impacts on pattern of allocation of resources and income distribution. Fiscal policy is used by government to influence economic aggregate demand in the need to achieve price stability, economic growth and full employment.
According to Kogan, (2003), tax cuts stimulate the economy together with intervention of interest rates and deficit spending. Economic stimulation can only be realized if the government reduces its expenditure and the tax payers increase their expenditure especially on local commodities. The free market economy advocates argue that economic welfare of people will be improved since people are rational in what they want than the government.
The suppliers of economy advocate for tax cuts because they stimulate the economy if the government expenditure is maintained and tax payers spend more of their income on locally produced commodities. This stimulates the economic growth but only on condition that it is properly maintained, otherwise it leads to economic inflation. If the expected revenue increase in the long term is not realized, the government may be left with huge debts to pay and hence a dangerous budgetary crisis.
In order that the government determines that the tax cut is or is not worth to the economy, the tax multiplier is used, which measures aggregate production changes as a result of