Assume that, without taxes, the consumption schedule for an economy is shown in
ID: 1185955 • Letter: A
Question
Assume that, without taxes, the consumption schedule for an economy is shown in the first two columns of the table below.
Suppose that a lump-sum (regressive) tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP and enter the tax, disposable income, consumption, and tax rate in the table below.
Instructions: For the tax, disposable income, and consumption after tax columns, enter whole numbers for your answers. For the tax rate column, enter two decimal places for your answers.
(Billions) Consumption
Before Tax
(Billions) Tax
(Billions) Disposable
Income
(Billions) Consumption After Tax
(Billions) Tax
Rate
(Percent)
$100 $120 $ $ $ % 200 200 % 300 280 % 400 360 % 500 440 % 600 520 % 700 600 %
Explanation / Answer
D. GDP falls by less than $10 billion
Reduced government purchases will decrease GDP by the dollar amount of the reduction, in this case $10 billion. At the same time, reduced taxes will increase consumption spending, which will increase GDP. This increased consumption will not be equal to the decreased government spending, however, because of the MPC: some of the tax cuts will be spent, some will be saved. Only the amount spent will go back into GDP. While we do not know what the numerical value of the MPC is, it surely is somewhere between 0 and 1 (by definition it must not be less than 0 or more than 1), which means that GDP will fall by something less than $10 billion. The only way it GDP could stay the same would be if MPC = 1, which is not a realistic outcome for a tax decrease.