Multiplier and income tax cuts

Readers Question: Explain how a change in the rate of income tax is likely to affect the size of the national income multiplier ?

The National Income Multiplier says that an initial increase in spending (injections J) can cause further rounds of spending. Therefore, the final increase in National Income (Y) is greater than the initial spending (or injection of money)

multiplier

For example, if the government cuts income tax by a total of £3 billion. That means National Income increases by £3 billion. However, if workers spend part of their extra disposable income, additional output and incomes will be generated. The final increase in national income may be £4 billion. Therefore, there is a multiplier effect of 4/3 = 1.33

multiplier-effect

What determines the size of Multiplier?

  • The size of the multiplier depends on withdrawals and the marginal propensity to consume
  • If nurses spend 90% of their extra income, the multiplier effect will be high. If they spend only 10% of extra income the multiplier effect will be low.
  • A cut in income tax means that people keep a high % of their gross income. Therefore the multiplier effect will be higher. A cut in income tax is a withdrawal – leading to less spending and therefore it reduces the size of the multiplier.
  • Multiplier Formula = 1 / 1-mpc
  • It depends on which rate of income tax is cut. For example, high-income earners have a lower marginal propensity to consume – they find it harder to find things they need to buy. If you cut the top rate of income tax, a higher % of the tax cut will be saved. Therefore, the multiplier effect will be lower.
  • If the income tax rate for low-income earners is cut (e.g. raising income tax threshold). This will have a bigger impact on increasing spending because low-income earners have a higher marginal propensity to spend.
  • Ricardian equivalance. It may also depend on whether households expect the tax cut to be temporary or permanent. For example, if the government cut taxes by increasing borrowing, then householders may feel in the future tax rates will have to rise to reduce the deficit. In this case, more of the tax cut will be saved rather than spent.
  • Marginal propensity to import (MPM). If the economy has a high propensity to spend extra income on imports, then the multiplier effect will be lower.
  • State of the economy. If the economy is close to full capacity, a cut in income tax may cause only a minor increase in real output. – the tax cut will be inflationary. However, if there is spare capacity (the economy is in recession) then the multiplier effect will be bigger as the tax cut may encourage unused resources to become used.

Conclusion

A tax cut can lead to an economic stimulus. But, it depends. For example, the Republican tax cut of 2018 was focused on high-income earners and corporations. Also, it occurred when the economy was growing strongly. The multiplier effect will be limited. iTax cut of 2018

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By on January 16th, 2017

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