Answer to Question #153993 in Macroeconomics for Sandeepa Jans

Question

Explain carefully why the tax multiplier [ΔY/ ΔT = -b/ (1-b)] is negative and why it is smaller in absolute value than the government expenditure multiplier [ΔY/ ΔG = 1/ (1- b)].

Answer 1

Solution:

The tax multiplier is usually negative since there exists an inverse relationship between taxes and aggregate demand. When there is a reduction in taxes, aggregate demand increases. As taxes increase, disposable income decreases, which then results in a decrease in consumption and GDP. An increase in tax decreases disposable income because disposable income is equal to total income minus current taxes.

The tax multiplier is smaller in absolute value than the government expenditure multiplier because the whole government expenditure affects the total expenditure and taxes through the multiplier. The tax multiplier also affects disposable income that affects the entire consumption level. The increase in government expenditure goes towards aggregate demand increase, yet only a portion of the increased disposable income as a result of the reduced taxes is consumed.