Government expenditure and taxation

Government expenditure and taxation: E = C + I + G

The government influences the level of national income in an economy in two ways:

1. Through the level of government expenditure on goods and services, G. It is assumed that
government expenditure is autonomous (fixed). Therefore G  G 0 .
Government expenditure will increase the level of national income (for any given value of
the expenditure multiplier) through its effect on the value of the autonomous components
of expenditure. That is,

1
Ye  . (C 0  I 0  G 0 )
1 b

2. Through taxation, denoted by the symbol, T, which is assumed to be a fixed rate of

T
income; therefore, T = tY, where t is the marginal propensity to tax: t  MPT  and
Y
0 < t < 1. The latter measures the fraction of income which is paid as taxes for each unit
increase in income. The imposition of taxes will reduce the level of national income (for
any given value of expenditure) through its effect on the value of the expenditure
multiplier.
(Note: Tax may also be a lump sum tax,  T 0 ).

When tax is imposed, consumption expenditure is a function of disposable income, Yd ,

where,

Yd  Y  T  Y d  Y  tY  Y d  (1  t )Y

The consumption function is now written as,

C  C 0  bYd
 C 0  b(1  t )Y ... substituting in Yd  (1  t )Y

Note: With taxes the slope of the consumption function, b(1 - t) decreases; since b(1 - t) < b.
The equilibrium condition is now given as,

Y  E  C I G
 C 0  b(1  t )Y  I 0  G 0

Solving the equilibrium equation for Y gives an expression for the equilibrium level of
national income for the given three sector economy,

Y  b(1  t )Y  C 0  I 0  G 0
Y[1  b(1  t )]  C 0  I 0  G 0
1
Ye  . (C 0  I 0  G 0 ) (3.31)
1  b(1  t )
© John Wiley and Sons 2013
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