April 2011 - Q36

[Rebecca.Thomas]

I'm obviously not expecting a reply to this before the exam, but I'm curious...

April 2011, Q36 - "Explain the effect on the multiplier of an increase in income tax rate".

My thought process was (and still is, even after reading the solution):
higher tax rate -> less disposable income -> 'poorer' people -> less able to save and hence higher mpc -> increased multiplier

Basically I'm thinking that higher the tax, the less disposable income, the higher the proportion that is spent on basic essentials, leaving less propensity to save and hence higher propensity to consume.


I'm sure I'm missing some "bigger picture" here!

 

[Graham Aylott]

Hi Rebecca,

No, the point here is that a higher tax rate will mean that people have less money to consume, so that the mpcd will decrease, leading to a fall in the multiplier.

Or even more directly, an increase in the tax rate will lead to an increase in the marginal propensity to pay tax (mpt). Consequently, more money will be withdrawn from the circular flow of income, resulting in a smaller multiplier.

Remember that the multiplier can be calculated (in terms of the marginal propensities to withdraw spending from the circular flow) as:

k = 1/(mps + mpt + mpm)

So, an increase in the mpt will lead to an increase in the denominator and hence a fall in the the multiplier.

I hope this helps.

Graham