The marginal propensity to consume is 0.75 and the government collects a proportional income tax at the rate of 0.2 (no other taxes). Autonomous investment falls by Rs 40 crore. By how much does consumption expenditure fall once the multiplier process is complete?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Rs 60 crore
With a proportional tax, consumption changes by only c(1 − t) of each change in income. The multiplier is 1 ÷ [1 − c(1 − t)].
Given:
c = 0.75
t = 0.2
ΔI = −40 (Rs crore)
\( \displaystyle c(1 - t) = 0.75 \times 0.8 = 0.6 \)
\( \displaystyle k = \frac{1}{1 - 0.6} = 2.5 \)
\( \displaystyle \Delta Y = 2.5 \times (-40) = -100 \)
\( \displaystyle \Delta C = 0.6 \times (-100) = -60 \)
Consumption falls by Rs 60 crore. The tax makes consumption fall less, which is why it is called an automatic stabiliser.
Option (2) Rs 75 crore — this uses c alone and forgets the tax.
NCERT (2026-27): “Box 5.1: Fiscal Policy … With proportional taxes, consumption will rise by less, (c – ct = c (1 – t)) times the increase in income. For changes in G, the multiplier will now be given by …” “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. …” |