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What is a Tax Multiplier?

Definition: The tax multiplier represents a measure of the change of the Gross Domestic Product (GDP) in response to a change in government taxes. The TM can be simple or complex, depending on whether the change in taxes has an impact only on consumption or on all the GDP components.

What Does Tax Multiplier Mean?

What is the definition of tax multiplier? TM is broadly used by economists, investors, and governments to analyze how fiscal policy changes in taxation affect the aggregate production. The simple tax multiplier is more common. It implies that only consumption expenditures are affected by a change in the aggregate production as a result of a change in the government taxes.

In fact, the governmental taxes affect the disposable income of consumers, which in turn affects both their savings and consumption rate. In contrast, the complex multiplier implies that a change in the aggregate production as a result of a change in the government taxes affects the aggregate expenditures, not only the consumption expenditures.

Letís look at an example.

Example

The US government decides to decrease the tax rates by 5.6%. It is estimated that this decrease in the tax rates will lower the total tax volume by $428 billion. At the same time, consumer spending will increase by $428 billion as consumers will have a higher disposable income since they will pay less in taxes.

Furthermore, consumers will be able to save more as their tax expenditures will be lower due to the decrease in the governmental tax rates. Therefore, the decrease in the government taxes triggers an increase in disposable income, which triggers an increase in consumption, which triggers an increase in production to meet demand. In the long-term, the GDP will increase by the tax multiplier to match the decrease in the government tax rates.

If the US government decides to increase the tax rates by 5.6%, the total tax volume will increase by $428 billion and consumer spending will decrease by $428 billion. Furthermore, savings will decrease. Therefore, the increase in the government taxes triggers a decrease in disposable income, which triggers a decrease in consumption, which triggers a decrease in production. In the long-term, the GDP will decrease by the tax multiplier to match the increase in the government tax rates.

Summary Definition

Define Tax Multiplier: Tax multiplier is an economic formula that calculates the effect of changing tax policies on the output and consumption of a country.

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