It's payday! Whether you receive your paycheck weekly, bi-weekly, or monthly, you are faced with a choice: to spend or save. This decision plays a crucial role in shaping government fiscal policy. Your spending and saving habits have an impact on the economy through the tax effect, which influences GDP. Read on to understand why these decisions are vital for fiscal policy actions!
Understanding the Tax Multiplier in Economics
Economic theory measures the tax's impact on GDP. By adjusting taxes precisely, the government can control the desired change in GDP. This tool allows for accurate tax adjustments instead of rough estimates.
Your choice to spend or save your paycheck affects GDP through the tax multiplier effect.
However, a 10% tax cut does not lead to a 10% increase in aggregate demand. When you receive income, you allocate some to saving and some to spending. Only the portion that is spent contributes to aggregate demand, while the saved portion does not.
So, how do we calculate the GDP change resulting from tax adjustments like those in figure 1?
The answer lies in the tax multiplier!
The tax multiplier, also known as the simple tax multiplier, is a term used interchangeably. Both refer to the same concept, so don't get confused!
Impact of the Tax Multiplier
Changes in taxes alter the tax multiplier effect. Taxes and consumer spending have an inverse relationship: higher taxes reduce consumer spending. Therefore, governments need to assess the economic situation before adjusting taxes. During a recession, lower taxes are needed, while in times of inflation, higher taxes are preferred.
The multiplier effect occurs when consumers have more disposable income. Increased spending leads to higher aggregate demand, while reduced spending results in lower aggregate demand. Governments use the tax multiplier equation to effectively manage aggregate demand.
Equation for the Tax Multiplier
The tax multiplier equation is as follows:
Tax Multiplier = - (MPC / MPS)
Where:
MPC refers to the marginal propensity to consume
MPS refers to the marginal propensity to save
The negative sign in front of the fraction is because a decrease in taxes will increase spending.
The sum of MPC and MPS is always equal to 1. For every $1, any part that is not saved will be spent, and vice versa. Therefore, MPC and MPS must equal 1 when added together, as you can only spend or save part of the $1.
The MPC represents the amount a household will spend from each additional $1 added to their income, while the MPS represents the amount a household will save from each additional $1 added to their income.
Tax and Spending Multiplier Relationship
The tax multiplier increases aggregate demand by a smaller amount compared to the spending multiplier. This is because when the government spends money, it spends the exact agreed-upon amount, let's say $100 billion. On the other hand, a tax cut incentivizes people to spend only a portion of the tax cut while saving the rest. This makes the tax cut "weaker" in comparison to the spending multiplier.
To learn more about this topic, read our article!
Tax Multiplier Example
Illustrating a tax multiplier example is essential for governments to decide on the right tax adjustment. Simply knowing whether to raise or lower taxes is not enough. We will cover two examples.
Tax Multiplier Example: Multiplier Effects on Spending
To complete this example, we need to make a few assumptions. Let's assume that the government plans to increase taxes by $50 billion, and the MPC and MPS are 0.8 and 0.2, respectively. Remember, their sum must be 1!
What we know:
- Tax Multiplier = - MPC / MPS
- GDP = Change in Taxes × Tax Multiplier
- Tax Change = $50 billion
Substituting into the Tax Multiplier equation:
Tax Multiplier = -0.8 / 0.2
Calculating the Tax Multiplier:
Tax Multiplier = -4
Calculating the Change in GDP:
GDP = Tax Change × Tax Multiplier
GDP = $50 billion × (-4)
GDP = -$200 billion
The change in GDP resulting from a $50 billion increase in taxes is a decrease of $200 billion based on our tax multiplier. This example highlights the importance of adjusting taxes during inflationary or recessionary periods.
What does the answer tell us? When the government raises taxes by $50 billion, spending will decrease by $200 billion based on our tax multiplier. This example provides crucial information to the government.
It demonstrates that governments need to carefully change taxes to navigate through inflationary or recessionary periods!
Tax Multiplier Example: Calculating for a Specific Tax Change
In the previous example, we discussed how changes in taxes can impact spending. Now, let's explore a real-world scenario where governments use the tax multiplier to address a specific economic problem.
In this example, let's assume that the economy is currently in a recession and requires a boost in spending by $40 billion. The MPC is 0.8, and the MPS is 0.2.
Given this situation, how should the government adjust its tax policies to combat the recession?
What we know:
- Tax Multiplier = - MPC / MPS
- GDP = Change in Taxes × Tax Multiplier
- Government Spending = $40 billion
Substituting into the Tax Multiplier equation:
Tax Multiplier = -0.8 / 0.2
Calculating the Tax Multiplier:
Tax Multiplier = -4
Calculating the Change in Taxes:
GDP = Change in Taxes × Tax Multiplier
$40 Billion = Change in Taxes × (-4)
Dividing both sides by -4:
Change in Taxes = $10 Billion
What does this mean? If the government wants to increase spending by $40 billion, it needs to decrease taxes by $10 billion. Intuitively, this makes sense—a decrease in taxes should stimulate the economy and encourage people to spend more.