Question

          Question 4:

         (a) Define both the tax and expenditure multiplier. Under what conditions might the tax multiplier be larger in value than the expenditure multiplier?
  

(b) What are the possible supply-side impacts of tax cuts on the economy?
  

(c) How does the Ricardian equivalence view of the effects of tax cuts (and budget deficits) differ from the traditional view? Discuss two objections to the Ricardian equivalence view.                                                                                    

Answer 1

4a) Tax multiplier measures the impact of changes in tax rate on income. The tax rate and disposable income is negatively related. An increase in the tax rate decreases the disposable income and vice versa.

∆Y/∆T = - mpc/(1- mpc)

Expenditure multiplier measures the impact of increase in government purchases on GDP. It is positively related ie higher the government purchase, more is the GDP.

∆Y/∆G = 1/(1- mpc) .

Generally expenditure multiplier is greater than tax multiplier because increase in government purchases stimulates the aggregate demand curve where as a fall in the tax rate(tax multiplier) only affects consumption ( disposable income). Therefore if a tax cute induces proportionately moreconsumption relative to increase in government purchases induces aggregate demand, then tax multiplier would be larger than expenditure multiplier.

b)The tax cuts impact the supply curve both directly and indirectly. Lower tax rate means consumer has more disposable income. Thus consumer can spend more on goods and services and also can save more. The increase in the demand for goods and services affect the supply side of the market. They produce more to meet the demand. Further rise in the saving boost investment and thus expansion of productive capacity. Moreover, a lower tax rate induces people to work more. Thus people will work more and their productivity also rises. This increases the overall supply of goods and services in the economy.

C) Ricardian equivalence is an economic theory given by Ricardo and Barro. They advocated that expansionary fiscal policy(either increase in government purchases or decrease in tax rate) which is used to stimulate economy cannot achieve its target because the policy cannot stimulate demand. The rise in income resulting from expansionary fiscal policy will be saved by people rather than spending on goods and services.Consumers are forward looking and they internalise the government budget deficit while making the decision of consumption. They think that today's tax cute or increase in government spending will be financed by raising taxes tomorrow so they ultimately have to pay taxes. Thus increase in government purchases is crowd out by fall in the private consumption.

Traditional view states that either an increase in government spending or decrease in the tax rate(expansionary fiscal policy) stimulates the aggregate demand. Rise in the income leads to increase in spending on goods and services by households. Thus over all GDP increases through expenditure multiplier effect.

Objections to Ricardian Equivalence:

1) Some economists argue that Ricardian Equivalence theory is unrealistic because people generally do not save for hypothetical future taxes and also they do not ignore the current rise in income for paying future taxes.

2) Further it is been seen that during recession or economic slowdown government plays an important role in stimulating the economy through tools at its disposal. Lower tax rate induces consumption spending and drives the growth rate of the economy.