CFA Level I · CFA Level I Exam · Fiscal Policy
Compared with an equal-sized change in government spending, a change in personal income taxes is most likely to have a smaller initial effect on aggregate demand because:
Part of a tax change is saved rather than spent. Government spending adds to aggregate demand in full, whereas a tax cut raises disposable income and households spend only a fraction of it. This makes the tax multiplier smaller than the spending multiplier.
- Apart of the tax change is saved rather than spentCorrect
- Btax changes always take effect immediately
- Ctaxes have no effect on disposable income
Explanation
Government spending enters aggregate demand in full. A tax change first alters disposable income, and households save some fraction, so only the portion spent (the marginal propensity to consume) changes demand. This is why the tax multiplier is smaller than the spending multiplier.
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