The marginal propensity to consume is 0.75. The government raises lump-sum taxes by 40, keeping its spending unchanged. What will be the change in equilibrium income?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → A fall of 120
Given:
MPC, c = 0.75
Rise in lump-sum taxes, ΔT = 40
The tax multiplier is −c/(1 − c). It is negative because a tax rise cuts consumption.
Tax multiplier = −0.75 ÷ 0.25 = −3
ΔY = −3 × 40 = −120, a fall of 120
A tax works only through disposable income, so its multiplier is one less than the expenditure multiplier.
Option (4) A fall of 160 — this uses the expenditure multiplier 4.
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). …” |