Final answer:
An increase in taxes reduces disposable income, leading to a decrease in consumption per worker in the long run, and a leftward shift in the aggregate demand curve. This typically results in lower price levels, output, and potentially employment. Conversely, a tax cut increases disposable income and consumption, boosting aggregate demand.
Step-by-step explanation:
An increase in taxes will have a negative impact on consumption per worker (c) in the new steady state level in the long run. This is because a tax increase reduces the amount of disposable income consumers have, which leads them to decrease their consumption. With less consumption, the aggregate demand (AD) curve shifts to the left, which can help alleviate inflation by reducing the price level and output in the economy.
To understand this better, it's also useful to look at what happens when taxes are cut. A tax cut leads to an increase in aggregate demand, as it raises disposable income and stimulates consumption by the amount of the marginal propensity to consume times the increase in disposable income. However, when considering an increase in taxes, the opposite happens – consumption decreases, potentially reducing output and employment in the economy.
The impact on the labor supply is also significant. A tax cut could lead to an increase in the quantity of labor supplied and hence an increase in potential output or real GDP. Assuming no change in the equilibrium real wage due to the tax cut, firms and laborers would both benefit.