Tax Multiplier

Tax Multiplier Effect

Depending on whether fiscal policy actions increase or decrease taxes will change the tax multiplier effect. Taxes and consumer spending are inversely related: increasing taxes will decrease consumer spending. Therefore, governments need to know what the current state of the economy is before altering any taxes. A recessionary period will call for lowers taxes, whereas an inflationary period will call for higher taxes.

The multiplier effect occurs when money can be spent by consumers. If more money is available to consumers, then more spending will occur — this will lead to an increase in aggregate demand. If less money is available to consumers, then less spending will occur — this will lead to a decrease in aggregate demand. Governments can utilize the multiplier effect with the tax multiplier equation to alter aggregate demand.

Fig 2. - Increasing aggregate demand

The graph above in figure 2 shows an economy in a recessionary period at P1 and Y1. A tax decrease will allow customers to spend more of their money since less of it is going to taxes. This will increase aggregate demand and allow the economy to reach equilibrium at P2 and Y2.

Tax Multiplier Equation

The tax multiplier equation is the following:

$TaxMultiplier=-\frac{MPC}{MPS}$

The marginal propensity to consume (MPC) is the amount a household will spend from each additional $1 added to their income. The marginal propensity to save (MPS) is the amount a household will save from each additional $1 added to their income. The formula also has a negative sign in front of the fraction since a decrease in taxes will increase spending.

The MPC and MPS will always equal 1 when added together. Per $1, any amount that you do not save will be spent, and vice versa. Therefore, MPC and MPS must equal 1 when added together since you can only spend or save part of the $1.

Tax Multiplier Example

Let's look at a tax multiplier example. Governments use the tax multiplier to determine what the change in taxes should be. Simply knowing whether to increase or decrease taxes is not sufficient. We will go over two examples.

Tax Multiplier Example: Multiplier Effects on Spending

We will have to make a few assumptions to complete an example. We will assume that the government plans to increase taxes by $50 billion, and the MPC and MPS is .8 and .2 respectively. Remember, they both have to add up to 1!

What does the answer tell us? When the government raises taxes by $50 billion, then the spending will go down by $200 billion given our tax multiplier. This brief example provides the government with very important information.

This example shows that governments need to carefully alter taxes to get an economy out of an inflationary or recessionary period!

Tax Multiplier Example: Calculating for a specific Tax Change

We went over a brief example of how spending is affected by a change in taxes. Now, we will look at a more practical example of how governments may use the tax multiplier to address a specific economic issue.

We will have to make a few assumptions to complete this example. We will assume that the economy is in a recession and needs to increase spending by $40 billion. The MPC and MPS is .8 and .2 respectively.

How should the government change its taxes to address the recession?

What does this mean? If the government wants to increase spending by $40 billion, then the government needs to decrease taxes by $10 billion. Intuitively, this makes sense — a decrease in taxes should stimulate the economy and incentivize people to spend more.