Why is the tax multiplier smaller than the government spending multiplier?
If the government spends, say, $100, then somebody's income goes up by $100. That is, the initial, first round increase in income is $100. This is in turn, spent on something else or saved -- depending on the MPC. The additional spending is, in-turn, saved or spent by the next person. And so on, creating the multiplier.
In the case of taxes, if someone gets a tax cut of $100, that person, we assume, will increase spending and savings according the MPC. So, the initial, first round, increase in income is 100*MPC.
The tax multiplier is generally smaller than the government spending multiplier because taxes have a different impact on the economy compared to government spending. To understand why the tax multiplier is smaller, we need to consider how changes in taxes and government spending affect aggregate demand.
The government spending multiplier measures the effect of a change in government spending on aggregate demand. When the government increases spending, it directly injects money into the economy, stimulating economic activity. This spending then ripples through the economy as people and businesses that receive that money also spend, creating a multiplier effect. This can lead to a larger overall increase in output and economic activity.
On the other hand, the tax multiplier measures the effect of changes in taxes on aggregate demand. When taxes are increased, people and businesses have less disposable income. As a result, they tend to reduce their spending, which dampens economic activity. This reduction in spending creates a smaller multiplier effect compared to government spending.
In addition, taxes can also affect incentives for work, investment, and consumption behavior, further impacting economic activity. Higher taxes can discourage individuals and businesses from working, investing, and spending, which can have a negative impact on economic growth.
To calculate the tax multiplier, you can use the formula: Tax Multiplier = - MPC / (1 - MPC), where MPC represents the marginal propensity to consume (the proportion of additional income that individuals or businesses spend rather than save).
In summary, the tax multiplier is smaller than the government spending multiplier because changes in taxes tend to have a dampening effect on economic activity, reducing the overall multiplier effect.