Q.Explain why the tax multiplier is smaller in absolute value than the government expenditure multiplier.
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Start your 14-day free trial to unlock the full solution →The tax multiplier is smaller than the government expenditure multiplier because a rupee of tax cut enters the spending stream only after passing through the household's marginal propensity to save, whereas a rupee of government spending enters directly as full demand.
The key to understanding this difference lies in the first round of spending. When the government increases its own expenditure (say, on roads or salaries), that entire amount becomes income for someone — a construction worker, a supplier, a teacher. That income is then spent, saved, and re-spent through the multiplier process. The initial injection is 100% of the spending.
A tax cut works differently. When the government reduces taxes, households have more disposable income. But they do not spend the entire tax cut. Part of it is saved. Only the fraction equal to the marginal propensity to consume (MPC) actually becomes new spending in the first round. The rest leaks out as saving.
Government expenditure multiplier:
Tax multiplier:
Notice the tax multiplier has an extra factor of in the numerator. Since is always less than 1 (a household never spends every extra rupee it gets — some is always saved), the absolute value of the tax multiplier is smaller than that of the government expenditure multiplier.
Let’s see this with numbers. Suppose the MPC is 0.8.
- Government expenditure multiplier =
- Tax multiplier =
A ₹100 crore increase in government spending raises national income by ₹500 crore. A ₹100 crore tax cut raises income by only ₹400 crore. The tax cut is 20% less effective because ₹20 crore of the initial ₹100 crore was saved, not spent. …
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