Question

Why does a reduction in taxes have a smaller multiplier effect than an increase in government spending of an equal amount? Tucker, Irvin B.. Macroeconomics for Today (Page 323). South-Western College Pub. Kindle Edition.

Answer 1

Both consumption spending and government spending are components of aggregate demand.

When government increases its spending, initially, aggregate demand increases by the same amount.

On the other hand, when taxes are reduced by the same amount as the increase in government spending then in such case, initially, disposable income of households increases by that amount.

However, households does not spend all their disposable income on consumption. They save some part of it.

So, initial spending on consumption is less than the initial increase in income due to reduction in taxes.

Due to this fact, initial increase in aggregate demand due to reduction in taxes is less than the initial increase in aggregate demand due to government spending of an equal amount.

Given the value of multiplier, this lower initial increase in aggregate demand due to reduction in taxes relative to government spending of equal amount leads to lower final increase in increase in aggregate demand due to reduction in taxes relative to government spending.

So, a reduction in taxes have a smaller multiplier effect than an increase in government spending of an equal amount.