Question

Consider the marginal tax rate (denoted t). It was noted in class that if t rises:

a. the spending multiplier with taxes will fall and there will be more output variability

b. the spending multiplier with taxes will rise and there will be less output variability

c. the spending multiplier with taxes will fall and there will be less output variability

d. the spending multiplier with taxes will rise and there will be more output variability

Answer 1

Ans.- (C)
Spending multiplier with taxes = 1/(1-c(1-t))

Let c = 0.5 and t = 0.5,

Spending multiplier = 1/(1-0.5*0.5) = 1/0.75 = 1.33

Now, if tax rate increases to 0.75 and c remains same then:

spending multiplier = 1/(1-0.5*0.25) = 1.14

Thus, a higher t leads to a lower spending multiplier and therefore any change in spending will have lower effect on output and hence there will be less output variability.