Tax Multiplier - The Investment Function, Macroeconomics | Macro Economics - B Com PDF Download

Tax Multiplier 

We know that a tax increase results in a decline in income. In other words, it is contractionary in effect. An increase in tax (∆T) leads to a decrease in income (∆Y). The ratio of ∆Y/∆T, called the tax multiplier, is designated by K_T Thus,

K_T = ∆Y/∆T, and ∆Y = K_T. ∆T

Again, how much national income would decline following an increase in tax receipt depends on the value of MPC. The formula for K_T is

Thus, tax multiplier is negative and, in absolute terms, one less than government spending multiplier. If MPC = 3/4 then the value of K_T = (-3/4)/(1-3/4)= -3.an increase in taxes of Rs. 20 crore results in a decline of income of Rs. 60 crore. That is to

-60 = (-3/4)/(1-3/4)

In contrast, with an MPC = 3/4, the value of K_G = 4. Assume an increase in government expenditure of Rs. 20 crore. Applying the formula for K_G, we obtain

Thus, K_T is negative and its value is one short of K, or K_G.

Graphically, tax multiplier has been shown in Fig. 3.18. Pre-tax consumption line and aggregate demand schedule are represented by C₁ and C, + I + G, respectively. The corresponding equilibrium level of income is OYI. An increase in taxes shifts the consum­ption line to C₂. Consequently, aggregate demand schedule also shifts downwards to C, + I + G. Consequently, income declines to OY₂. Thus, the effect of an increase in taxes on income is contractionary.

One must know the distinction between K_I or K_G and K_T.This is demonstrated in terms to Table 3.4.

Thus, K_T is negative and one less than KI or K_G.

The G-multiplier and T-multiplier are also called fiscal multipliers as these multipliers are associated with the fiscal activities of the government (i.e., changes in expenditure and taxation plans).