Chapter 10: Fiscal Policy

Appendices

Appendices to Chapter 10 of Essentials of Economics in Context

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Essentials of Economics in Context – Chapter 10 Appendices

APPENDIX A: AN ALGEBRAIC APPROACH TO THE

MULTIPLIER, WITH A LUMP-SUM TAX

A lump-sum tax is a tax that is simply levied on an economy as a flat amount. This amount does
not change with the level of income. Suppose that a lump-sum tax is levied in an economy with a
government (but no foreign sector). Consumption in this economy is:

C = C + mpc Yd

(the consumption function from Chapter 9, but using after-tax or disposable income in the
formula). Since disposable income is:
Yd = Y – T + TR
we can write the consumption function as:

C = C + mpc (Y – T + TR)

Thus aggregate expenditure in this economy can be expressed as:

AE = C + I + G
= C + mpc (Y – T + TR) + I + G
= ( C – mpc T + mpc TR + I + G) + mpc Y

By substituting this into the equation for the equilibrium condition, Y = AE, we can derive an
expression for equilibrium income in terms of all the other variables in the model:

Y= ( C – mpc T + mpc TR + I + G) + mpc Y

Y - mpc Y = ( C – mpc T + mpc TR + I + G)
(1-mpc) Y = ( C – mpc T + mpc TR + I + G)
1
𝑌= ( C – 𝑚𝑝𝑐 T + 𝑚𝑝𝑐 𝑇𝑅 + 𝐼 + 𝐺)
(1 − 𝑚𝑝𝑐)

If autonomous consumption, investment, or government spending change, these each increase

equilibrium income by mult = 1/(1 – mpc) times the amount of the original change. If the level of
lump-sum taxes or transfers changes, these change Y by either negative or positive (mult)(mpc)
times the amount of the original change.

To see this explicitly, consider the changes that would come about in Y if there were a change in
the level of the lump sum tax from T0 to a new level, T1, if everything else stays the same. We can
solve for the change in Y by subtracting the old equation from the new one:

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Essentials of Economics in Context – Chapter 10 Appendices

1
𝑌1 = ( C + 𝐼 + 𝐺 – 𝑚𝑝𝑐 𝑇̅1 + 𝑚𝑝𝑐 𝑇𝑅)
(1 − 𝑚𝑝𝑐)
1
𝑌0 = ( C + 𝐼 + 𝐺 – 𝑚𝑝𝑐 𝑇̅0 + 𝑚𝑝𝑐 𝑇𝑅)
(1 − 𝑚𝑝𝑐)
1
𝑌1 − 𝑌0 = ( C − 𝐶̅ + 𝐼 − 𝐼 + 𝐺 − 𝐺 – 𝑚𝑝𝑐 𝑇̅1 + 𝑚𝑝𝑐 𝑇̅0 + 𝑚𝑝𝑐 𝑇𝑅 − 𝑚𝑝𝑐 𝑇𝑅)
(1 − 𝑚𝑝𝑐)

But C , I, G, TR (and the mpc) are all unchanged, so most of the subtractions in parentheses come
out to be 0. We are left with (taking the negative sign out in front):
1
𝑌1 − 𝑌0 = − 𝑚𝑝𝑐 (𝑇̅1 − 𝑇̅0 )
(1 − 𝑚𝑝𝑐)

or
∆Y = – (mult)(mpc)∆ T

As explained in the text, the multiplier for a change in taxes is smaller than the multiplier for a
change in government spending, because taxation affects aggregate expenditure only to the extent
that people spend their tax cut or pay their increased taxes by reducing consumption. Because
people may also save part of their tax cut or pay part of their increased taxes out of their savings,
not all the changes in taxes will carry over to changes in aggregate expenditure. The tax multiplier
has a negative sign, since a decrease in taxes increases consumption, aggregate expenditure, and
income, while a tax increase decreases them.

APPENDIX B: AN ALGEBRAIC APPROACH TO THE

MULTIPLIER, WITH A PROPORTIONAL TAX
With a proportional tax, total tax revenues are not set at a fixed level of revenues, as was the case
with a lump sum tax but, rather, are a fixed proportion of total income. That is, T = tY where t is
the tax rate. The equation for AE becomes

AE = C + mpc (Y – tY + TR) I + G
= C + mpc TR + I + G) + mpc (Y – tY)
= ( C + mpc TR + I + G) + mpc (1 – t) Y

Substituting in the equilibrium condition, Y = AE, and solving yields:

Y = ( C + mpc TR + I + G) + mpc (1 – t) Y
Y – mpc (1 – t) Y = C + mpc TR + I + G

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Essentials of Economics in Context – Chapter 10 Appendices

(1 – mpc (1 – t)) Y = C + mpc TR + I + G

1
𝑌=[ ] (𝐶̅ + 𝑚𝑝𝑐 𝑇𝑅 + 𝐼 + 𝐺)
1 − 𝑚𝑝𝑐(1 − 𝑡)

The term in brackets is a new multiplier, for the case of a proportional tax. It is smaller than the
basic (no proportional taxation) multiplier, reflecting the fact that now any change in spending has
smaller feedback effects through consumption. (Some of the change in income “leaks” into taxes.)
For example, if mpc = 0.8 and t = 0.2, then the new multiplier is 1/(1 – 0.64), or approximately
2.8, compared to the simple model multiplier 1/(1 – 0.8), which is 5. Changes in autonomous
consumption or investment (or government spending or transfers) now have less of an effect on
equilibrium income—the “automatic stabilizer” effect mentioned in the text.

Is there a multiplier for the tax rate, t? That is, could we derive from the model a formula for how
much equilibrium income should change with a change in the rate (rather than level) of taxes? For
example, if the tax rate were to decrease from 0.2 to 0.15, could we calculate the size of the change
from Y0 to Y1 illustrated in Figure 10.7? Yes, but deriving a general formula for a multiplier relating
the change in Y to the change in the tax rate requires the use of calculus, which we will not pursue
here. (If you are familiar with calculus, you can use the last formula above to calculate the change
in Y resulting from a change in t).

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