Why do lump sum taxes have no effect on how much consumers spend on consumption or...

Why do lump sum taxes have no effect on how much consumers spend on consumption or the fraction of their income that they choose to save?

in my macro class (using a made up economy), we used the assumption that lump taxes were autonomous. My professor said that this means a change in taxes would not affect the fraction of income the choose to spend on consumption or how much they decide to save. I don’t see how this is possible. If I’m making less money and prices remain the same, I would be spending much less.

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Expert Solution

You are absolutely right. But the question is not whether you are consuming less or more. It is whether your fraction of income spent, is changed or not. When there is a lump sum tax, it does not depend on your income level which means if the lump sum tax is set at $500, you will be paying a tax amount of$500 irrespective of your income.

You are definitely going to consume less because now you are paying taxes but the fraction of income that is spent will not change because it is assumed to be fixed at the rate of MPC. That is why in the equation of aggregate demand with lump sum taxes we have a multiplier 1/(1-MPC) because taxes are independent of income and consumer is assumed to consume MPC fraction of a given change in income.

Rahul Sunny answered 1 year ago

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