How do taxes impact aggregate demand?

Higher taxes lead to lower consumer spending, which directly impacts aggregate demand. When taxes increase, households have less disposable income available to spend on goods and services. This reduction in disposable income means individuals may cut back on their consumption and save more, leading to a decrease in overall spending in the economy.

Consumer spending is a primary component of aggregate demand, which also includes investment, government spending, and net exports. Therefore, when consumer spending diminishes due to higher taxes, aggregate demand shifts leftward, indicating a decrease in the total demand for goods and services in the economy.

This relationship illustrates the importance of fiscal policy—such as tax policy—in influencing macroeconomic performance. Higher taxes can dampen economic activity by reducing the funds consumers have to allocate towards purchasing, ultimately affecting overall economic growth and stability.