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Section 4: The Tax Multiplier and the Balanced Budget Multiplier 
Macroeconomics  Unit 5  
How a Change in Taxes Affects GDP Please make sure you have the latest version of Adobe Flash Player installed.
If an increase in government spending leads to an increase in total spending and GDP, then an increase in taxes must lead to a decrease in total spending and GDP, and vice versa. When the government raises taxes, private spending decreases. Keynes noted, however, that the decrease in overall spending from a tax increase is not as large as the increase in overall spending from the same amount of a government spending increase. The example in the next paragraph illustrates this. The Tax Multiplier Let's say that taxes increase by $1,000. Therefore, people's aftertax income (income available for consumption or savings) decreases by $1,000. If the MPC is 80%, then people would have only consumed $800 of this $1,000. Thus, total spending throughout the economy decreases by 5 (the multiplier) times $800 = $4,000. This $4,000 is 4 times the change in taxes. Mathematically, we can prove that the tax multiplier is the negative of the spending multiplier minus 1. In the above example, the regular spending multiplier from the previous section is 5 and, therefore, the tax multiplier is 4. Thus,
The following applications provide further explanations of this concept. Examples of How a Change in Taxes Affects GDP Please make sure you have the latest version of Adobe Flash Player installed.
Example 1 Solution: Because the MPC equals .75, the regular (spending) multiplier equals 4, and the tax multiplier equals 3. Recessionary Gap Example 2 Solution: We know that the decrease in taxes times the tax multiplier equals the increase in GDP. Inflationary Gap Example 3 Solution: The change in taxes x the tax multiplier = the change in GDP. The Balanced Budget Multiplier Please make sure you have the latest version of Adobe Flash Player installed.
When the government increases spending by a certain amount and it increases taxes by the same amount, then GDP will increase by that amount. The following example illustrates this. Example 4 Solution: The multiplier equals 5 and so the tax multiplier equals 4. Therefore, GDP will increase by $5,000 from the $1,000 additional government spending (5 times $1,000). And GDP will decrease by $4,000 from the additional $1,000 in taxes (4 times $1,000). Thus, on balance, equilibrium income (GDP) will increase by $1,000 ($5,000 minus $4,000). Therefore, when the government spends $1,000 and imposes taxes of $1,000, it balances its budget, while increasing equilibrium GDP by $1,000. Thus, when the government changes spending and taxes by the same amount, then equilibrium income (GDP) changes by 1 times this amount. We say that
The balanced budget multiplierimplies that if the government increases spending and taxation by the same amount, then equilibrium national income (GDP) rises by this amount. This balanced budget stimulation is possible, according to Keynes, because when the government receives $1,000, it spends it all. On the other hand, when private citizens receive $1,000, they spend only a fraction of it (in the above example, they spend 80%). They save the other fraction. Because savings, according to Keynes, is a "leakage" from the economy, the economy "loses" 20% in stimulation if private citizens spend it, compared to no loss (no savings) if the government spends it. Do you agree with Keynes that it is possible to stimulate the economy by, for example, $1 trillion, simply by raising government spending and taxes by $1 trillion?


Last Updated on Wednesday, 17 June 2015 05:55 