Taxes, the Multiplier Effect, and Automatic Stabilizers
20. Fiscal Policy
Taxes, the Multiplier Effect, and Automatic Stabilizers - Video Tutorials & Practice Problems
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Taxes and the GDP Multiplier
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So we saw how the multiplier effect works with a change in government spending. Now, let's see how the multiplier effect works with taxes. So it's very similar to a change in government spending. Remember the multiplier effect? It's how an initial boost in spending leads to a much higher increase in GDP. Okay, well, in this case we're not really changing an initial boost of spending. What we're doing is making more money or less money available to the households. Okay, generally, when we deal with the multiplier effect, it's a situation where we're gonna increase, right, we're gonna have some sort of increase. So when there's a decrease in taxes, I know I just said an increase but a decrease in taxes leads to an increase to household income, right? Because if you're paying less taxes, you have more disposable income available, I'll say disposable income because disposable income is what we spend on consumption and savings. So in this case, it's kind of an inverse relationship, A decrease in in taxes leads to higher income. So this increase in income leads to higher household consumption, right? So this is very similar to what we saw in the government spending multiplier right now, in this case, there's no initial boost in spending, like we said, Oh, the government's gonna spend an additional $5 billion. No, here, they're just making more money available by lowering taxes. So this increase in household consumption again, is going to have a chain reaction because the extra money that's being spent is being earned by someone else who's gonna spend some of it, it'll be earned and that cycle will continue. So that's that multiplier effect happening again. There's that second round of spending leading to more consumption, a third round of spending. It's gonna go go on and on like that. Now there's a difference here with the government multiply government spending multiplier and the tax multiplier, the tax multiplier tends to be a little smaller in magnitude because there's not that initial boost of spending happening by the government. This is just a little extra income that the households have. So it tends to be a little smaller where where the government purchases multiplier um might have been, let's say four X. Maybe this one will be 3.5 X. Or something like that, a little smaller in general? Um It just tends to be like that. And another note here is that the tax multiplier is negative, right? Because what did we see up here? A decrease in taxes leads to an increase in income, Right? So they they have this inverse relationship, lower taxes, higher income, right? A decrease in taxes leads to an increase in consumption. Okay, so they have this inverse relationship meaning by lowering taxes, we increase consumption. So some of that extra disposable income that you get goes to savings, right? We don't spend it all. And that leads to smaller chain reactions happening than in the government purchases multiplier. However, we see a very similar thing happening on the graph, there's going to be increases to aggregate demand. Right? When there's this decrease in tax, well, there's gonna be this first increase And this will be will say from uh from boost in consumption. No one I'm making up this term here, That's not like an official term or boosting consumption the first time. And then there's that chain reaction and it'll be a little smaller the second time. So this this uh decrease in taxes is going to eventually lead to this. Maybe this final line here where it all plays out after a few times through the chain reaction, we finally reach our new aggregate demand as it keeps uh chain reacting through the economy. These increases in consumption. So when we talk about the tax multiplier, we use a little bit of a different equation because like I said, it's not as uh generally not as large as the regular multiplier. So what we're gonna do is we're gonna see how much our GDP has changed the change, right? This little triangle, change in equilibrium GDP divided by change in taxes. So you can imagine it's gonna be negative, right? Because if we have a negative, let's say uh 10 billion of taxes, they decreased taxes by 10 billion. Let me get out of the way here and do this in a different color. There's a decrease of 10 billion in taxes Leading to, you know, 30 billion Of extra GDP. Right? The change in GDP by lowering taxes 10 billion GDP goes up by 30 billion. Well, then we've got a tax multiplier of negative three here, right? And it's negative because we're lowering taxes to increase our consumption, leading to increase GDP. Okay, so it's very similar in effect. What happens with a decrease in taxes or an increase in government spending? Okay, so the multiplier effect works in both cases. Let's pause here and let's discuss a little bit more about taxes on the next page.
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Taxes as an Automatic Stabilizer
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So we mentioned in the introduction to fiscal policy, how taxes can be an automatic stabilizer in the economy. Remember, automatic stabilizer is where there's no change in the fiscal policy. However, the amount of taxes being paid are gonna change. Uh Just based on where we are in the business cycle, when the when the economy is booming, what more taxes are being paid. So let's go ahead and see what this means. So one note we want to make is that government purchases are not really an automatic stabilizer, they're gonna stay stable regardless of the business cycle right there, they're gonna stay stable whether or not uh we're in a recession or or boom. Um unless there's some discretionary policy unless the government steps in and changes something. Well, those spending is generally going to be stable. The amount of taxes, however, well that's based on the amount of income being earned, right? The amount of income earned means how much taxes are being paid. So when the economy is booming, like we've said before, there's gonna be more GDP more inflation, more income, which leads to more taxes. And when taxes are higher consumption goes down, right? There's less consumption. And then the opposite in a recession, while there's less money being made, less GDP less inflation, less income leading to lower taxes if there's less money being made and when there's less taxes, well consumption will increase because of that. Okay, now I want to make a note that in a recession, consumption generally is gonna be a lot lower than during an economic boom. However, this automatic stabilizer tries to fight it just a little bit. Okay so instead of consumption decreasing a ton this automatic stabilizer, well it's going to help in that decrease by boosting our consumption back up just a little bit. Okay so let's see how this automatic stabilizer looks on the graph. Like I said the so what we have on this graph is the amount of government spending or taxes on this axis and the amount of G. D. P. So based on the amount of G. D. P. We're gonna have changes in the amount of taxes but government spending is gonna stay relatively stable. Like I said above without any fiscal without any discretionary policy going on the government stepping in and saying hey we need to increase spending or decrease spending we're gonna have very stable government purchases. So this could be our government purchases right here. There's not going to really be a change in government purchases um in a recession or an expansion without someone stepping in. However taxes are going to be affected when GDP is low. So when we're in a recession let's say we're gonna have a low amount of taxes right? Just like we said a recession leads to less taxes. Just like we saw up here recession lower taxes which leads to more consumption which is what we want. Right? But when the when the economy is booming well we're gonna have a lot of taxes, we'll have something like this. Right? So notice what's happening here. We this is the automatic stabilizer at play. Here during a recession. We have less taxes. And then here during an expansion, there's more taxes. Okay. So that's the idea of the automatic stabilizer. Is that without without stepping in and changing anything, we already have a change in the amount of taxes being collected just based on where we are in the business cycle. Okay. Um, so that's about it for the automatic stabilizer. It's just the idea that it's changing based on where we are in the business cycle. Let's go ahead and move on to the next video.
