How does decreased taxation crowd out investment?

Jean: How does decreased taxation crowd out investment?
According to my economics textbook, a decrease in taxation will increase consumption, and in a situation where the factors of production are fixed, this means investment must decrease. However, it doesn’t explain how this would logically happen. Why would the interest rate increase when consumption goes up?

Answers and Views:

Answer by mmmmm
It depends the type of taxation which is reduced.

I presume it means income tax. This would mean consumption would increase as people have more money to spend.

Think of a production possibility frontier of capital and consumer goods. If you increase the production of consumer goods (to meet the sudden increases in demand), the number of capital goods you invest in has to reduce because you would have limited resources.

Interest rates could go up because as consumption rises, the aggregate demand curve would shift to the right. This would cause inflation. In this circumstance, some governments would increase interest rates in order to control inflation. If they rise the interest rates, people would consume less because it is more expensive to get loans off the banks and thus inflation would slow down.

Answer by iamthegreatbandini
Throw your textbook away. If taxes are reduced then only one thing is certain: people will have more of their own money and government will have less of it. People may choose to save all of that extra income in which case investment will actually increase. Further, even if people choose to consume some of the tax reduction (because invariably some will be saved and invested) this will just be a transfer from government consumption to personal consumption (i.e. from politically directed consumption to market directed consumption).

The interest rate may increase if the government continues consuming at the same rate as previous, in which case they will need to borrow to make up the difference. The increased demand for borrowing might crowd out private borrowing which could lead to a decrease in investment. Of course, the increased price of money will also naturally increase supply.