Question

suppose the government, in an effort to avoid an increase in the deficit, votes for a budget neutral tax cut policy. assume the marginal propensity to consume (mpc) is equal to 0.75 and taxes are cut by $15 billion . round answers to the nearest billion, and specify decreases as a negative number.

Answer 1

A $15 billion tax cut with an MPC of 0.75 leads to an increase in consumption of $11.25 billion. The tax cut policy aims to be budget neutral, intending not to increase the deficit. Initial national savings could decrease unless offset by other budget-balancing measures.

Step-by-step explanation:

When the government enacts a budget neutral tax cut policy, and if the marginal propensity to consume (MPC) is 0.75, the impact on consumption can be determined. With a tax cut of $15 billion, households will increase their spending by 0.75 of that amount because the MPC indicates the proportion of additional income that households are likely to spend on consumption.

In this scenario, the additional consumption would therefore be $11.25 billion (0.75 * $15 billion). However, this tax cut policy aims to be budget neutral, which implies that it must not increase the government budget deficit. This is typically achieved by offsetting the tax cuts with decreases in government spending or with other measures to balance the budget.

It is important to note that when taxes are cut and if spending doesn't change, national savings could initially decrease by the amount of the MPC because this policy would decrease government savings by increasing its budget deficit, unless, of course, the policy is indeed budget neutral.

Answer 2

Under these assumptions, the budget-neutral tax cut policy would result in a decrease in real GDP of $4 billion (rounded to the nearest billion).

How did we get the value?

To analyze the impact of the budget-neutral tax cut policy, we can use the concept of the fiscal multiplier. The fiscal multiplier represents the overall change in real GDP resulting from a change in government spending or taxes.

The formula for the fiscal multiplier is given by:

`\[ \text{Fiscal Multiplier} = \frac{1}{1 - \text{MPC}} \]`

Given that the MPC (Marginal Propensity to Consume) is 0.75, we can substitute this value into the formula:

`\[ \text{Fiscal Multiplier} = (1)/(1 - 0.75) \]`

`\[ \text{Fiscal Multiplier} = 0.25 \]`

This means that for every dollar cut in taxes, the overall impact on real GDP will be four times that amount.

Now, since taxes are cut by $15 billion, and the fiscal multiplier is 4, we can calculate the overall impact on real GDP:

`\[ \text{Impact on GDP} = \text{Fiscal Multiplier} * \text{Change in Taxes} \]`

`\[ \text{Impact on GDP} = 0.25 * (-$15 \, \text{billion}) \]`

`\[ \text{Impact on GDP} = -$3.75 \, \text{billion} \]`

Therefore, under these assumptions, the budget-neutral tax cut policy would result in a decrease in real GDP of $4 billion (rounded to the nearest billion).