Tax Cuts and the Tax Multiplier
Lower income taxes raise disposable income and consumption, and the tax multiplier moves AD by less than an equal-sized change in government spending.
Tax Cuts and the Tax Multiplier
Fiscal Policy (AD-AS)Lower income taxes raise disposable income and consumption, and the tax multiplier moves AD by less than an equal-sized change in government spending.
Equilibrium at Real GDP (Y) 92, Price Level (PL) 66
Output below potential
The economy starts with AD crossing SRAS to the left of LRAS, so real GDP is below the full-employment level of output and a recessionary gap is open. This time policymakers do not buy anything themselves. They work through households by changing what those households get to keep.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
Tax Cuts and the Tax Multiplier, step by step
- 1
Output below potential
The economy starts with AD crossing SRAS to the left of LRAS, so real GDP is below the full-employment level of output and a recessionary gap is open. This time policymakers do not buy anything themselves. They work through households by changing what those households get to keep.
- 2
Disposable income rises, AD shifts right
A lower income tax rate leaves households with more disposable income out of the same pretax pay. Consumption (C) is a component of aggregate demand, so households buy more at every price level and AD shifts right, and the multiplier process passes that new spending along to the firms and workers who receive it. Nothing has changed the cost of producing a unit of output, so SRAS stays where it is.
- 3
Why the tax multiplier is smaller
A dollar of government purchases enters aggregate demand in full, because the government spends all of it. A dollar of tax cut only enters when a household spends it, and households save part of any tax cut. Only the MPC share gets spent in that first round, which is why the tax multiplier is -MPC/(1 - MPC), smaller in absolute value than the spending multiplier 1/(1 - MPC). A tax cut therefore has to be larger than a spending increase to move AD the same distance.
- 4
The gap closes
AD crosses the unchanged SRAS at a higher real GDP and a higher price level, and output has climbed back to the full-employment level marked by LRAS. The recessionary gap is closed and unemployment returns to its natural rate. Cut taxes further than this and AD would keep moving right, opening an inflationary gap on the other side of full employment.
Where it ends up
A tax cut raises disposable income and consumption, so AD shifts right and real GDP and the price level both rise. The shift is smaller per dollar than a rise in G, because the tax multiplier is smaller than the spending multiplier.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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