The marginal propensity to consume is 0.8 and taxes are lump-sum. Investment falls by 100. By how much must the government cut lump-sum taxes to keep equilibrium income unchanged?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → 125
Given:
MPC, c = 0.8
Fall in investment, ΔI = −100
First find the fall in income. The investment multiplier is 1/(1 − c).
Multiplier = 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5
Fall in income = 5 × 100 = 500
A tax cut must raise income by 500. The tax multiplier is c/(1 − c) in absolute value.
Tax multiplier = 0.8 ÷ 0.2 = 4
Tax cut needed = 500 ÷ 4 = 125
Option (1) 100 — a tax cut of only 100 raises income by 400, which is not enough.
A tax cut works through disposable income, and only a part c of it is spent in the first round, so the cut must be larger than the fall in investment.
This question uses Determination of Income and Employment and Government Budget and the Economy together.
NCERT (2026-27): “Box 5.1: Fiscal Policy … Because a tax cut (increase) will cause an increase (reduction) in consumption and output, the tax multiplier is a negative multiplier. Comparing equation (5.6) and (5.8), we find that the tax multiplier is smaller in absolute value compared to the government spending multiplier. This is because an increase in government spending directly affects total spending whereas taxes enter the multiplier process through their impact on disposable income, which influences household consumption (which is a part of total spending). …” “A tax cut of 100 ( ΔT= –100) will increase equilibrium income by 400. Thus, the equilibrium income increases in this case by less than the amount by which it increased under a G increase.” |