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Taxes and the Aggregate Expenditure Function

2 March, 2015 - 12:11

Suppose that the only difference between real GDP and disposable personal income is personal income taxes. Let us see what happens to the slope of the aggregate expenditures function.

As before, we assume that the marginal propensity to consume is 0.8, but we now add the assumption that income taxes take ¼ of real GDP. This means that for every additional $1 of real GDP, disposable personal income rises by $0.75 and, in turn, consumption rises by $0.60 (= 0.8 × $0.75). In the simplified model in which disposable personal income and real GDP were the same, an additional $1 of real GDP raised consumption by $0.80. The slope of the aggregate expenditures curve was 0.8, the marginal propensity to consume. Now, as a result of taxes, the aggregate expenditures curve will be flatter than the one shown in Figure 28.8 and Figure 28.10. In this example, the slope will be 0.6; an additional $1 of real GDP will increase consumption by $0.60.

Other things the same, the multiplier will be smaller than it was in the simplified economy in which disposable personal income and real GDP were identical. The wedge between disposable personal income and real GDP created by taxes means that the additional rounds of spending induced by a change in autonomous aggregate expenditures will be smaller than if there were no taxes. Hence, the multiplied effect of any change in autonomous aggregate expenditures is smaller.