I know the answer is A. but I need an explanation on why. I thought government savings would decrease since they have less tax revenue, shifting savings left and interest rates up. I could see how public savings could also increase due to this new taxation cut but consumers would spend part of the tax break, resulting in less of an increase in savings compared to decrease in government savings. What am I missing here? Thanks.
The best way to think about this in terms of an intro course is to break down “total savings” into “private savings” plus “public savings.”
Private savings: Y-T-C
Public savings: T-G
If you sum these, taxes drop out, so changes in the level of taxation do not affect the supply of loanable funds.
However, this tax change specifically affects the taxation of savings. It’s a decrease in the tax on interest income, which should spur households to save more and consume less. Thus, the result of the change is an increase in private savings.
Not to confuse the issue too much, as I don’t know how you’re being taught, but I will note that the notion that government “savings” contribute to loanable funds is disputed, as it involves an implicit assumption that government spending does not result in productive investments.
From a practical standpoint, it’s often better to think of government borrowing as contributing to the demand for loanable funds instead, though many intro courses do not teach it this way.
Most governments (outside of typically oil-producing nations that have sovereign wealth funds) are net debtors, so even if they run a surplus, that shows up primarily as a decrease in government bonds outstanding (i.e., lower demand for funds).
If you think about it this way, then you can let changes in the level of taxation be neutral with respect to the supply of loanable funds, but you’ll still see “crowding out” effects as a result of deficits, as the increased demand for funds results in a higher equilibrium interest rate.