Taxation is one of the most important subjects you will come across when studying economics, accounts or any other topic which is related to commerce. Neither individuals of a particular country nor the government of the same can undermine the overwhelming importance of tax. In fact, there are hundreds of countries all across the globe that are heavily reliant on tax collection and their economies are based on such.
There are many aspects related to taxation. Moreover, there are many different kinds of taxes that are levied. From income tax and sales tax to different custom duties, there is a variety that you will come across.
One thing you will often hear is taxation and multiplication. Even though this sounds a bit daunting since these terms do not go well together. It can be a burden on the individual who is supposed to pay the taxes. However, this article will essentially guide you over the concept of tax multiplier and how it has a major impact on the economy of a particular nation. It will also outline how the taxation of any country can have an impact on the gross domestic product, which is perhaps a major indicator of any economy. Therefore, here is everything you need to know about the tax multiplier formula.
Tax Multiplier Formula
Taxes are one of the most important ways for the government to earn revenue and therefore, run the economy. These are issued not only at a macro-economic level but also at micro-levels. It is an ancient concept which can be traced back hundreds of years ago.
One of the major questions that a lot of taxpayers come across is how the government alter taxes in order to impact the GDP of a country. Any country produces millions of goods and services within a particular time. The value of the same is termed as GDP by economists. The measure of this effect is called the tax multiplier. In essence, the disposable income is changed by the taxes which further has an impact on the changes in savings and consumption. In other words, it is a representation of the multiple by which the GDP has either increased or decreased due to a change in the taxation regime.
There are several methods in which the tax multiplier can be calculated. Each method has its own benefit. One method is pretty much simple while the other one is slightly complex. The simpler method is much easy in terms of calculation and even gives us information that is needed. On the other hand, the complex method is a reflection of valuable information but it also shows the complexity within the economics. Each method engages in the evaluation of propensity to spend and save. Both of these variables are termed as marginal propensity to save and marginal propensity to consume, respectively.
Hereby, we will only discuss the simple version of the formula which makes it pretty much easy to understand for laypeople. In the simple version of the tax multiplier formula, it is presumed that any decrease or any increase in the tax will only be impactful on the consumption and therefore, it does not have any sort of impact on government expenses, investment or other variables.
Following is the formula:
TM = MPC/MPS = MPC/ (1-MPC)
TM is representative of the simple tax multiplier;
MPS is representative of marginal propensity to save; and
MPC is representative of marginal propensity to consume.
When the value of marginal propensity to consume is kept the same, the value of spending multiplier remains more than the simple tax multiplier. The reason behind that is when the government expenses are increased, the consumption is also increased by 100%. On the other hand, when the taxes of the same amount are decreased, the consumption is increasingly taking into account the marginal propensity to consume.
For example, if tax refunds of value $1 million are paid by a government, this will result in an increase of approximately $3 million in the real gross domestic product. This means that the tax multiplier is -3. It is pertinent to note that the tax multiplier will always be a negative number.
There are some misconceptions within the tax multiplier formula. Some people think that increasing government spending will have the same influence as decreasing taxes. This is not the case. Spending will have more impact than changing taxes.
Another major mistake that a lot of people, even experienced economists make is that they mistakenly put the same sign for spending multiplier and tax multiplier. It is important to note that the tax multiplier always has a negative sign. The expenditure multiplier is supposed to be positive.
Tax Multiplier Formula Example
In order to understand anything, it is imperative to understand it with an example. Following is an example that can be reviewed to have a better understanding of how the tax multiplier formula works.
Sammy Gordon works as a major economist in the budget office of Ukraine. The country is currently going through a variety of financial problems and the government is looking forward to coming up with financial strategies in order to overcome the issues and bring it back on a positive trending growth. The growth target has been missed by the country and finance minister, Brown Dan, wants to give the required stimulus to the economic conditions of the country. In order to get to the target growth rate, the country needs to expand its GDP by at least $40 billion. There is currently a budget deficit and a lot of opinions have been asked by experts in order to get an idea of whether the government should increase their taxes or decrease them. It has been suggested by other advisors that the country has a marginal propensity to save of 0.2. There are various solutions proposed different professionals from economic backgrounds based on their experiences.
Explanation of tax multiplier formula example
Here are the explanation and the solution of the hypothetical example given above.
Increasing GDP can be done in multiple ways. One of the effective ways is to increase government expenditures and investment. Although the taxed can be decreased as well in order to increase the GDP, it is not as effective as the former method. The target that is to be achieved by the country is of approximately $40 billion. This can be done by increasing the expenses of the government and also raising investment of $10 billion. Further $13.3 billion of tax should be reduced if the country wants to achieve the target growth. The main reason behind that is that the tax multiplier is low than the spending multiplier. The calculations in relation to this example are shown herein below:
Spending multiplier in Ukraine: 1/MPS = 1/0.25 = 4
Tax multiplier in Ukraine: MPC/(1-MPC) = 0.75/0.25 = 3
Above is the solution to the example which will help you understand how the tax multiplier formula works and its importance within the economies of the nation all across the globe. It is better to understand in a practical sense to have a better idea about it.
What are the uses of tax multiplier formula?
Fiscal policy is one of the most important subjects for any government that is elected. Main two key points for deciding a fiscal policy is either to change the standards of taxation or the standard of spending.
Given the importance of fiscal policy, it is pertinent to note that tax multipliers can be important to use when deciding fiscal policy. Governments often use these indicators in order to strategize their fiscal policy and therefore, achieve their economic targets.
Economies of the world utilize tax multiplier formula to understand how much growth they need in terms of GDP. The usage is purely on a governmental level that levy taxes and earn revenue. It has a major impact on other economic indicators as well.
The bottom line
Above were some of the most important things that you need to know about the tax multiplier formula. However, this is not an exhaustive list. There are several other important things that can be discussed about the term in detail. The complex formula has more complexities within it which reflects other things as well that are important for an economy. A lot of people consider these formulas in order to understand the economy at a macro level and make decisions in relation to the strategy to be formed for an economy.
At the bottom line, it is advisable for you to go through different hypothetical scenarios in order to understand how the formula works. It will enable you to have a better and practical understanding of the issue. Most importantly, it will provide a deeper insight into the actual economic scenarios. In case the scenarios are too complex, it is recommendable to consult with experts who can provide a holistic answer to the query and make you understand in a more effective manner.