How is the tax multiplier calculated?

The tax multiplier measures the impact of changes in taxes on the overall economy, specifically on aggregate demand. It is calculated using the formula that incorporates the marginal propensity to consume (MPC). The correct calculation involves the negative of the MPC divided by the difference between 1 and the MPC.

When individuals experience a tax cut, they are likely to spend a portion of that extra income based on the MPC. However, since a tax cut only affects disposable income and not total income directly as government spending does, the impact on aggregate demand is magnified by the MPC but adjusted to reflect that only a portion of the tax cut will lead to new spending. Therefore, the tax multiplier results in a smaller effect compared to the government spending multiplier.

The negative sign indicates that an increase in taxes will lead to a decrease in output, while a tax cut will lead to an increase in output. This is significant in Keynesian economics as it highlights the relationship between consumer behavior and fiscal policy. Understanding this relationship is crucial for analyzing fiscal policy's effectiveness and its influence on the economy.