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CA Foundation · Business Economics · Determination of National Income

In a three-sector economy with a lump-sum tax (taxes independent of income), the marginal propensity to consume out of disposable income is 0.8. Which of the following correctly gives the government expenditure multiplier and the tax multiplier?

The government expenditure multiplier is 5 and the tax multiplier is -4. With MPC 0.8, 1/(1-0.8) equals 5, and the tax multiplier is -MPC/(1-MPC), which equals -4. The negative sign shows that higher taxes reduce income, and the tax effect is smaller than the spending effect.

  1. AGovernment expenditure multiplier = 5; tax multiplier = -4Correct
  2. BGovernment expenditure multiplier = 4; tax multiplier = -5
  3. CGovernment expenditure multiplier = 5; tax multiplier = +4
  4. DGovernment expenditure multiplier = 1; tax multiplier = -4

Explanation

With lump-sum tax, the government expenditure multiplier = 1/(1-MPC) = 1/0.2 = 5. The tax multiplier = -MPC/(1-MPC) = -0.8/0.2 = -4. Option B swaps the two values, a common error, and option C ignores that a tax rise reduces income.

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