Final answer:
An increase in tax rates that collects an additional $20 million would decrease consumption by $18 million due to the marginal propensity to consume of 0.90. This could lead to a decrease in GDP of up to $180 million due to the multiplier effect.
Step-by-step explanation:
When the marginal propensity to consume is 0.90, this implies that for every additional dollar earned, individuals will spend 90 cents. If the government increases tax rates and collects an additional $20 million, this money is extracted from the economy and is not available for consumption. Since people consume 90% of every additional dollar, this reduction in private spending power translates to a decrease in consumption by $18 million (90% of the $20 million tax increase).
According to the multiplier effect, a decrease in consumption can lead to a larger decrease in gross domestic product (GDP). The initial decrease in spending is amplified throughout the economy as one person's spending is another person's income. Thus, an $18 million decrease in consumption could lead to a larger reduction in GDP, depending on the size of the multiplier which can be determined by the formula 1 / (1 - marginal propensity to consume). In this case, the multiplier would be 1 / (1 - 0.90) = 10. Therefore, the overall decrease in GDP could be up to $180 million (10 times the initial $18 million decrease).