Fiscal Policy and the Tax Multiplier
We now consider how changes in taxes affect equilibrium income. A decrease in taxes immediately raises disposable income by and, therefore, increases consumption by . For any level of income , planned expenditure is now higher and hence the planned expenditure schedule shift upward by :
Since the current is 0.30, a tax cut of 0.00 shifts the planned expenditure schedule by 0.00. The equilibrium of the economy moves from point A to point B, and income rises from to .
Just as an increase in government purchases has a multiplied effect on income, so does the decrease in taxes. As before, the initial change in expenditure, now , is multiplied by . The overall effect on income of the tax change is:
This expression is the tax multiplier, the amount income changes in response to a $1 change in taxes. (The negative sign indicates that income moves in the opposite direction from taxes). In this example, the is 0.30 and hence the tax multiplier is -0.30/(1 - 0.30) = -0.30/0.70 = -0.43 . A $1 cut in taxes raises equilibrium income by $0.43 . We can explore how this multiplier is affected by a change in the :