The marginal propensity to consume is 0.8. In a recession, GDP falls by Rs 100 crore. Compare a fixed (lump-sum) tax with a proportional income tax at the rate of 0.25. In the first round, by how much LESS does consumption fall under the proportional income tax?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Rs 20 crore
Given:
MPC, c = 0.8
Fall in GDP = Rs 100 crore
Proportional tax rate, t = 0.25
Consumption depends on disposable income. A fixed tax stays the same, so disposable income falls by the full fall in GDP. A proportional tax also falls, so disposable income falls less.
Fixed tax:
Fall in disposable income = 100
Fall in consumption = 0.8 × 100 = 80
Proportional tax:
Fall in tax = 0.25 × 100 = 25
Fall in disposable income = 100 − 25 = 75
Fall in consumption = 0.8 × 75 = 60
Consumption falls less by 80 − 60 = Rs 20 crore
Option (2) Rs 25 crore — this is the fall in tax, not the difference in consumption.
Option (4) Rs 60 crore — this is the fall in consumption under the proportional tax alone.
NCERT (2026-27): “Box 5.1: Fiscal Policy … The proportional income tax, thus, acts as an automatic stabiliser – a shock absorber because it makes disposable income, and thus consumer spending, less sensitive to fluctuations in GDP. When GDP rises, disposable income also rises but by less than the rise in GDP because a part of it is siphoned off as taxes. This helps limit the upward fluctuation in consumption spending. During a recession when GDP falls, disposable income falls less sharply, and consumption does not drop as much as it otherwise would have fallen had the tax liability been fixed. This reduces the fall in aggregate demand and stabilises the economy. …” |