Suppose that Congress enacts a lump-sum tax cut of $750 billion. The marginal propensity to consume is equal to .075. Assuming that Ricardian equivalence holds true, what is the effect on equilibrium real GDP? On saving?
To determine the effect of a lump-sum tax cut on equilibrium real GDP and saving, we need to understand the concept of marginal propensity to consume (MPC) and Ricardian equivalence.
The marginal propensity to consume (MPC) represents the change in consumption for every additional dollar of income. In this case, the MPC is given as 0.075, meaning that for every additional dollar of income, individuals will consume $0.075 and save the rest.
Ricardian equivalence suggests that individuals anticipate future tax obligations and adjust their current saving and spending accordingly. It assumes that individuals understand that a decrease in taxes today may result in future tax increases to repay the debt incurred from the tax cut.
Given these concepts, let's analyze the effects of the lump-sum tax cut on equilibrium real GDP and saving:
1. Effect on equilibrium real GDP:
By implementing a lump-sum tax cut, individuals have more disposable income. According to the MPC, they will consume a portion of this additional income and save the rest. However, since Ricardian equivalence assumes individuals understand the future tax implications, they may choose to save more, anticipating future taxes to repay the debt.
The change in equilibrium real GDP depends on the multiplier effect. The multiplier is the factor by which an initial change in spending (or income) expands or contracts total output. The multiplier formula is: Multiplier = 1 / (1 - MPC).
In this case, the MPC is 0.075, so the multiplier would be: Multiplier = 1 / (1 - 0.075) = 1 / 0.925 ≈ 1.08.
Using the multiplier, we can calculate the change in equilibrium real GDP: Change in GDP = Lump-sum tax cut * Multiplier = $750 billion * 1.08 ≈ $810 billion.
Therefore, the lump-sum tax cut of $750 billion would lead to an increase in equilibrium real GDP by approximately $810 billion.
2. Effect on saving:
Due to Ricardian equivalence, individuals may save a larger portion of their additional income to prepare for future tax obligations. The increase in saving reduces consumption and dampens the impact of the tax cut on aggregate demand.
However, without specific data on the saving function or assuming a constant MPC, it is challenging to measure the exact change in saving resulting from the lump-sum tax cut in this scenario.
In summary, a lump-sum tax cut of $750 billion, assuming Ricardian equivalence holds true, would increase equilibrium real GDP by approximately $810 billion. The effect on saving is more uncertain as it depends on individual behaviors and assumptions about the saving function.