The marginal propensity to consume is 0.8 and taxes are lump-sum. To raise equilibrium income by Rs 200 crore, the government can either raise its purchases by Rs X crore or cut lump-sum taxes by Rs Y crore. What are X and Y?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → X = 40; Y = 50
Government purchases work through the multiplier 1 ÷ (1 − c); a tax cut works through the smaller tax multiplier c ÷ (1 − c).
Given:
c = 0.8
ΔY = Rs 200 crore
\( \displaystyle \text{Government expenditure multiplier} = \frac{1}{0.2} = 5 \)
\( \displaystyle X = \frac{200}{5} = 40 \)
\( \displaystyle \text{Tax multiplier} = \frac{0.8}{0.2} = 4 \)
\( \displaystyle Y = \frac{200}{4} = 50 \)
X is 40 and Y is 50. A bigger tax cut is needed, because part of a tax cut is saved.
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). …” “A tax cut of 100 ( ΔT= –100) will increase equilibrium income by 400. Thus, the equilibrium income increases in this case by less than the amount by which it increased under a G increase.” |