Question

True or False AND explain why:

a. If G > T, the government budget is in a surplus.

b. A tax cut will increase equilibrium Y, and a tax increase will decrease equilibrium Y.

c. If the MPC = .6, the tax multiplier is -1.5.

Answer 1

Ans (a)- In fiscal policy, G stands for government spending and T stands for tax revenue. G> T implies that government spending is more than the tax revenue. This is called expansionary fiscal policy. Under this policy government spends more on public infrastructure, health and defence. This situation gives a boost to the economy but reduce government treasure. When this kind of situation occurs in an economy this leads to budget deficit. Thus, from above explanation it is clear that sentence in the question is false. Because when G> T government budget will be in deficit.

Ans ( b)

There is relationship between tax rates and disposable income and national income (Y). If tax rates changes it will also affect disposable income and national income of the country. Let's first consider a scenario of tax cut. If government reduces tax rates by 5%, that means people have to pay 5% less of their actual tax payment. To his will increase their disposable income ( income left after tax payment). This increased disposable income will lead to increase in aggregate demand and consumption level. From, supply point of view, lower tax rates will help the firm's to use this extra amount saved from the tax for further investment and this will provide employment and further increase in aggregate demand and overall increase in national income.

Consider the second scenario where tax rates increase. Suppose tax rates increase by 5%.now people have to pay extra 5% of their actual tax payment. This will reduce their disposable income in relation to national income. Because of this people will not be able to demand more and their consumption level will also decrease. Thus will lead to reduction in aggregate expenditure and equilibrium national income. From, supply point of view higher tax rates reduces profit of the business people and their ability to invest. Because of higher tax rates they will not be able to invest and provide employment. Such situation will lead to higher prices, low wages and reduced aggregate demand and low aggregate expenditure and lower equilibrium national income.

Thus, second statement in the question is true because tax cuts leads to higher national income and increase in tax leads to lower equilibrium national income.

Ans (c)

If MPC is 0.6 then tax multiplier will be

formula for tax multiplier

tax multiplier= MPC/ (1-MPC)

= 0.6/ 1-0.6

= 0.6/ 0.4

= 1.5

A tax multiplier calculates the amount that a decease in tax rate will generate in an economy.

Third statement in the question is false. Because from above explanation it is clear that tax multiplier will be positive 1.25. This means decease tax rate will lead to increase economic activity in the country.