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

The government spending multiplier is given by the formula:

k = 1/(1-c) where c = marginal propensity to consume.

At c = 0.5 (say), an increase in government spending by 1 unit will lead to a 1/(1-0.5) i.e. 2 times increase in total output.

On the other hand, tax multiplier is given by the formula:

k = -c/(1-c)

At c= 0.5, the tax multiplier is 1.

Clearly, a 1 unit decrease in tax will lead to an increase in output by 1 time.

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