The marginal propensity to consume is 0.8 and the government collects a proportional income tax at the rate of 0.25. The government raises its transfer payments by 30, and nothing else changes. By how much does equilibrium income rise?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → 60
Transfers add to autonomous spending only through what households spend out of them, so autonomous expenditure rises by cΔTR. This rise then works through the multiplier with proportional taxes, 1 ÷ [1 − c(1 − t)].
Given:
c = 0.8
t = 0.25
ΔTR = 30
\( \displaystyle \Delta A = c\,\Delta TR = 0.8 \times 30 = 24 \)
\( \displaystyle \text{Multiplier} = \frac{1}{1 - 0.8 \times 0.75} = \frac{1}{0.4} = 2.5 \)
\( \displaystyle \Delta Y = 2.5 \times 24 = 60 \)
Equilibrium income rises by 60.
Option (1) 24 — Incorrect. This is only the rise in autonomous expenditure, before the multiplier works.
Option (3) 75 — Incorrect. This multiplies the whole transfer of 30 by 2.5. But households save a part of any transfer.
Option (4) 120 — Incorrect. This uses the lump-sum transfer multiplier c ÷ (1 − c) = 4 and leaves out the proportional tax.
NCERT (2026-27): “Box 5.1: Fiscal Policy Transfers: We suppose that instead of raising government spending in goods and services, government increases transfer payments, TR … Autonomous spending, A , will increase by cΔTR … so output will rise by less than the amount by which it increases when government expenditure increases because a part of any increase in transfer payments is saved. …” “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. … 2.5 which is smaller than that obtained with lump-sum taxes. …” |