Question

Suppose marginal propensity to consume is 0.75 and there is a 20 per cent proportional income tax. Find the change in equilibrium income for the following (a) Government purchases increase by 20 (b) Transfers decrease by 20.

Answer 1

In case of proportional taxes

(a) ΔY = 1/(1 - c(1 - t)) x ΔG

MPC = 0.75 and ΔG = 20

= 1/(1 - 0.75(1 - 0.2)) x 20

= 1/(1 - 0.75 x 0.8) x 20

= 20/(1 - 0.60)

= 20/0.4

= 50

(b) Transfer decreases by 20

ΔY = c/1 - c x ΔT

 = 0.75/(1 - 0.75) x 20

= 0.75/0.25 x 20

= 60