Taxes, the Multiplier Effect, and Automatic Stabilizers - Online Tutor, Practice Problems & Exam Prep

The Multiplier Effect illustrates how changes in taxes influence household income and consumption. A decrease in taxes increases disposable income, leading to higher consumption and a chain reaction of spending, albeit with a smaller multiplier effect compared to government spending. This tax multiplier is typically negative, indicating that lower taxes result in increased GDP. Additionally, taxes act as automatic stabilizers, adjusting based on the business cycle; during economic booms, taxes rise, reducing consumption, while in recessions, lower taxes boost consumption. Understanding these dynamics is crucial for grasping fiscal policy's impact on aggregate demand.

Taxes and the GDP Multiplier

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 going to increase, right? We're going to 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 in 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 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 going to spend an additional $5,000,000,000 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 going to 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 going to go on and on like that.

Now, there's a difference here with the 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 the government purchases multiplier might have been, let's say 4x. Maybe this one will be 3.5x or something like that. A little smaller, in general. 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 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. 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 going to be this first increase and this will be, we'll say, from boost in consumption number 1. I'm making up this term here. That's not an official term. We're boosting consumption the first time and then there's that chain reaction and it'll be a little smaller the second time. So this decrease in taxes is going to eventually lead to 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 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, generally not as large as the regular multiplier. So what we're going to do is we're going to 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 going to be negative, right? Because if we have a negative, let's say, $10,000,000,000 of taxes, they decrease taxes of $10,000,000,000 in taxes leading to, you know, $30,000,000,000 dollars of extra GDP, right? The change in GDP by lowering taxes, $10,000,000,000 GDP goes up by $30,000,000,000 Well, then we've got a tax multiplier of -three here, right? And it's negative because we're lowering taxes to increase our consumption leading to increased 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.

Taxes as an Automatic Stabilizer

So we mentioned in the introduction to fiscal policy how taxes can be an automatic stabilizer in the economy. Remember, an automatic stabilizer is where there's no change in fiscal policy. However, the amount of taxes being paid is going to change just based on where we are in the business cycle, especially when the economy is booming and more taxes are being paid. So let's go ahead and see what this means. One note we want to make is that government purchases are not really an automatic stabilizer. They're going to stay stable regardless of the business cycle, whether or not we're in a recession or a boom, unless there's some discretionary policy. Unless the government steps in and changes something, those spending will generally be stable. The amount of taxes, however, well, that's based on the amount of income being earned. The amount of income earned dictates how much taxes are being paid. So when the economy is booming, as we've said before, there's going to be more GDP, more inflation, more income, which leads to more taxes. And when taxes are higher, consumption goes down; there's less consumption. And then the opposite happens in a recession: there's less money being made, less GDP, less inflation, less income, leading to lower taxes. And when there's less tax, consumption will increase because of that. Now, I want to make a note that in a recession, consumption generally is going to be a lot lower than during an economic boom. However, this automatic stabilizer tries to fight it just a little bit. 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.

So let's see how this automatic stabilizer looks on a graph. As mentioned, what we have on this graph is the amount of government spending or taxes on this axis and the amount of GDP. Based on the amount of GDP, we're going to have changes in the amount of taxes, but government spending is going to stay relatively stable, as noted above, without any discretionary policy going on, without the government stepping in and saying, hey, we need to increase spending or decrease spending. We're going to 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, 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, we're going to have a low amount of taxes, just like we said, a recession leads to lower taxes which leads to more consumption, which is what we want. But when the economy is booming, we're going to have a lot of taxes. So notice what's happening here. 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. So that's the idea of the automatic stabilizer: that 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. 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.

Here’s what students ask on this topic:

What is the Multiplier Effect in relation to taxes?

The Multiplier Effect in relation to taxes refers to how changes in taxes influence household income and consumption. When taxes decrease, disposable income increases, leading to higher household consumption. This initial increase in consumption triggers a chain reaction of spending throughout the economy. However, the tax multiplier is typically smaller than the government spending multiplier because it lacks the initial boost in spending. The tax multiplier is also negative, indicating that a decrease in taxes results in an increase in GDP. This effect is crucial for understanding how fiscal policy impacts aggregate demand.

How do automatic stabilizers work in the economy?

Automatic stabilizers are mechanisms that adjust fiscal policy based on the business cycle without the need for government intervention. Taxes are a primary example. During economic booms, higher incomes lead to increased tax revenues, which reduce consumption and help cool down the economy. Conversely, during recessions, lower incomes result in reduced tax revenues, which boost consumption and help stimulate the economy. These automatic adjustments help moderate the fluctuations in the business cycle, providing a stabilizing effect on the economy.

Why is the tax multiplier typically smaller than the government spending multiplier?

The tax multiplier is typically smaller than the government spending multiplier because it lacks the initial boost in spending that government purchases provide. When the government increases spending, it directly injects money into the economy, leading to a larger chain reaction of spending. In contrast, a tax cut increases disposable income, but not all of it is spent; some is saved. This results in a smaller overall increase in consumption and a smaller multiplier effect. Additionally, the tax multiplier is negative, reflecting the inverse relationship between taxes and GDP.

How do changes in taxes affect aggregate demand?

Changes in taxes affect aggregate demand by influencing household disposable income and consumption. A decrease in taxes increases disposable income, leading to higher consumption and, consequently, an increase in aggregate demand. Conversely, an increase in taxes reduces disposable income, leading to lower consumption and a decrease in aggregate demand. The tax multiplier effect illustrates this relationship, showing how an initial change in taxes can lead to a larger overall change in GDP through a chain reaction of spending.

What role do taxes play as automatic stabilizers during a recession?

During a recession, taxes act as automatic stabilizers by adjusting based on the reduced economic activity. Lower incomes during a recession result in lower tax revenues, which leave households with more disposable income. This increase in disposable income helps boost consumption, mitigating the decline in aggregate demand. Although overall consumption is still lower than during an economic boom, the automatic reduction in taxes helps cushion the economy from a more severe downturn, providing a stabilizing effect without the need for active government intervention.