Question

A country Spartan is falling behind its growth target. It was estimated that GDP must grow by at least $40 bn to achieve the target growth rate. The country is already running in budget deficit. Should the taxes decrease or government expenditure increase to achieve the target growth. Given MPC = 0.25

Answer 1

We will have to find tax Multiplier and Government Spending Multiplier

Tax Multiplier= -MPC/1–MPC= -0.25/1-0.25= 0.33

Goverment Spending Multiplier= 1/(1-MPC)= 1.33

Change in Governnment spending Required= Increase in income required/Government Spending Multiplier= 40/1.33= $30.08 billion

Change in Taxes Required= Increase in Income required/Tax Multiplier= –40/0.33= –$121.21 billion.

To achieve the target growth rate, either Governnment Spending has to increase by $30.08 billion or Decrease taxes by $121.21.

Since both Option would Increase government deficit, an increase in Government Spending would be way better because the Increase in budget deficit would be less than an increase in Budget Deficit caused by Decrease in Taxes because because as compared to Decrease in Taxes, Increase in Spending is required to be increased by a smaller amount.

Thus, government expenditure should increase to achieve the Target Growth.