So another effect of government policy, or our fiscal policy, is the long-run tax policy. We use this idea of a tax wedge, which is the difference between pretax and post-tax income. Let's say you earn $20 an hour, but are taxed 25%. So, 25% of that is going to taxes. That means you're paying $5 of that wage in taxes, right? So, you're going to have $15 of income post-tax, and there's this $5 tax wedge. That's what we call the tax wedge: the difference between what you earned gross, at $20 an hour, and what you actually have left after taxes, $15.

You can imagine that the long-run effects of tax policy are going to have effects on the economy as well. The first one, we'll talk about how lowering taxes affects the economy. The lower the individual taxes, the more disposable income leading to more consumption, right? Just like we've talked about pretty consistently throughout this course. The lower the taxes, the more income you have, the more you can consume. And it's the same for corporate taxes because for firms, when there's lower corporate taxes, they are going to have higher returns leading to more investment, right? So when there's lower taxes, it leads to higher investment as well. Lower taxes also help on capital gains and dividends, so they increase the supply of loanable funds. When there's lower taxes, there's an increase in the supply of loanable funds because this is savings from households. Households are more likely to save when there's lower taxes, right? If there's lower taxes on their earnings from savings, because remember, if you earn any money from a savings, you're going to be taxed on that. So, the lower those taxes go, the more incentive you have to save.

When there's an increase in that supply of loanable funds, it's going to lower the interest rate as well. So there are benefits here to a long-run sustained lower tax policy. However, that needs to be balanced in a balanced budget. Remember, a budget deficit means the lower the taxes go, the spending has to come down too, right? To keep that balanced budget. So these are the effects that we'll see from long-run tax policy here. Alright? Let's go ahead and pause and we'll move on to the next video.