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Taxation and Equilibrium Output

Suppose the government decides to collect $40 billion in personal income taxes in order to finance its spending plans. How does this affect the equilibrium level of GDP? The initial impact of this action is to reduce disposable income—

EXHIBIT A.2. The Effect of Taxation

The Effect of Taxation

income after taxes, or take-home pay—by $40 billion. So long as we ignored taxes, total income (GDP) equaled disposable income (DI). But now that we are introducing taxes, this equality no longer holds. The imposition of taxes reduces the amount of disposable income that households have available at any given level of GDP. If disposable income declines, consumption spending will decline. Thus, the ultimate impact of taxation is a reduction in the amount of consumption spending at any given level of GDP. This can be represented by a downward shift of the consumption function, which, in turn, will cause a downward shift of C + I + G (the total expenditure function).

Exh. A.2 shows that the total expenditure function shifts downward by $30 billion when the government imposes taxes of $40 billion. Why doesn't the total expenditure function shift downward by $40 billion? The answer is that households react to reductions in disposable income by reducing both their consumption and their saving. If the marginal propensity to consume is .75, we know that 75 percent of the reduction in disposable income will come from planned consumption spending, and 25 percent will come from planned saving. Thus, the consumption function—and consequently the total expenditure function—will shift downward by 75 percent of $40 billion, or $30 billion.

Note that in this case the equilibrium level of GDP falls from $760 billion to $640 billion, a reduction of $120 billion. Once again, this represents the impact of the multiplier. The $30 billion reduction in consumption spending is magnified by the multiplier of 4 and thus produces a $120 billion reduction in GDP.

Given that government spending and taxation affect total spending and equilibrium output, let's see how changes in government spending and taxation can be used as economic policy tools to combat the problems of unemployment or inflation.

 
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