The government collects a constant fraction t of income as taxes (T = tY). Consider the following statements:
(A) The marginal propensity to consume out of income falls to c(1 − t).
(B) The aggregate demand schedule becomes flatter.
(C) The government expenditure multiplier becomes larger than with lump-sum taxes.
(D) With c = 0.8 and t = 0.25, the government expenditure multiplier is 2.5.
Choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → (A), (B) and (D) only
With a proportional tax, a part of every extra rupee of income goes as tax. So consumption rises by less for each rise in income.
(A) The marginal propensity to consume out of income falls to c(1 − t). — Correct. Only (1 − t) of income is left to spend, so the mpc out of income becomes c(1 − t).
(B) The aggregate demand schedule becomes flatter. — Correct. A lower mpc means a lower slope of AD.
(C) The government expenditure multiplier becomes larger than with lump-sum taxes. — Incorrect. The multiplier becomes smaller, 1 ÷ [1 − c(1 − t)].
(D) With c = 0.8 and t = 0.25, the government expenditure multiplier is 2.5. — Correct. c(1 − t) = 0.8 × 0.75 = 0.6, so the multiplier = 1 ÷ 0.4 = 2.5.
NCERT (2026-27): “Box 5.1: Fiscal Policy … We note that proportional taxes not only lower consumption at each level of income but also lower the slope of the consumption function. The mpc out of income falls to c (1 – t). The new aggregate demand schedule, AD′, has a larger intercept but is flatter as shown in …” “Comparing this with the value of the multiplier with lump-sum taxes case, we find that the value has become smaller. …” “In Example 5.1, if we take a tax rate of 0.25, we find consumption will now rise by 0.60 (c (1 – t) = 0.8 × 0.75) for every unit increase in income instead of the earlier 0.80. Thus, consumption will increase by less than before. The government expenditure multiplier will be … 2.5 which is smaller than that obtained with lump-sum taxes. …” |