Why does a higher income tax rate reduce the multiplier effect?

Short Answer

Expert verified
A higher income tax rate reduces the multiplier effect by decreasing disposable income and thus the Marginal Propensity to Consume (MPC). This reduction in consumption means less money is circulating in the economy, leading to a smaller multiplier effect.

Step by step solution

01

Understanding the Multiplier Effect

The multiplier effect in economics refers to the indirect impact on an economy due to a change in fiscal policy, like a change in public spending, which results in a larger change in national income than the initial amount spent. The multiplier effect is calculated by dividing 1 by (1 - Marginal Propensity to Consume). The Marginal Propensity to Consume (MPC) is the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it.
02

Understanding the Effect of Tax on Income

Income tax is a type of leaked spending from the economy. Leakage is any removal of money from the economy or the circular flow of income model, hence it will reduce the circular flow of income. Marginal Propensity to Tax (MPT) is the proportion of additional income that is paid in tax. When the tax rate increases, the Marginal Propensity to Tax (MPT) also increases.
03

Explaining the Effect of Higher Income Tax on the Multiplier

When the income tax rate increases, this means that a greater portion of each earned dollar is being taken out of the circular flow of income and into the government's coffers. This results in lower net income for consumers, reducing the Marginal Propensity to Consume (MPC), subsequently decreasing the size of the multiplier. In other words, a higher tax rate reduces the overall disposable income of consumers, which reduces their spending, and hence, reduces the multiplier effect.

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Most popular questions from this chapter

Which can be changed more quickly: monetary policy or fiscal policy? Briefly explain.

Identify each of the following as (1) part of an expansionary fiscal policy, (2) part of a contractionary fiscal policy, or (3) not part of fiscal policy. a. The corporate income tax rate is increased. b. Defense spending is increased. c. The Federal Reserve lowers the target for the federal funds rate. d. Families are allowed to deduct all their expenses for day care from their federal income taxes. e. The individual income tax rates are decreased.

Suppose that at the same time that Congress and the president pursue an expansionary fiscal policy, the Federal Reserve pursues an expansionary monetary policy. How might an expansionary monetary policy affect the extent of crowding out in the short run?

In The General Theory of Employment, Interest, and Money, , ohn Maynard Keynes wrote: If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise \(\ldots\) to dig the notes up again \(\ldots\) there need be no more unemployment and, with the help of the repercussions, the real income of the community \(\ldots\) would probably become a good deal greater than it is. Which important macroeconomic effect is Keynes discussing here? What does he mean by "repercussions"? Why does he appear unconcerned about whether government spending is wasteful?

What are the key differences between how we illustrate a contractionary fiscal policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?

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