# Introducing Taxes

Introducing taxes into an income-expenditure model forces us to be more careful with the assumption we make about consumption. Realistically, people should base consumption decisions not on total income, but on disposable income. There are a number of adjustments that had to be made to go from total spending or GDP to disposable income. Some income never gets to households because it stays in the business sector as depreciation or as retained earnings, and there are a number of adjustments involving both taxes and transfer payments. For the sake of simplicity, we will assume that the only adjustment in our model will be taxes. Disposable income will then be total income less taxes.

The introduction of taxes and consumption that depends on disposable income alters our table. The table below shows how the needed changes can be made. From expected income in column one we subtract taxes to give us expected disposable income. The consumption decisions in column four are based on this expected disposable income. The next two columns showing investment and government spending are similar to the fourth column in Table 2. We find actual income at each level of expected income by adding together consumption, investment, and government spending. Since spending by some is income for others, this summation gives us total income, which is shown in the last column. Equilibrium in this table should exist when expected income equals actual income, which happens when actual income is 22,500.

 Table 3: Taxes in the Income-Expenditure Model Expected Income Taxes Expected Disposable Income Consumption Investment Government Spending Actual Income \$12,500 \$2,500 \$10,000 \$12,500 \$500 \$2,000 \$15,000 14,500 2,500 12,000 14,000 500 2,000 16,500 22,500 2,500 20,000 20,000 500 2,000 22,500 32,500 2,500 30,000 27,500 500 2,000 30,000

If this table is graphed, it will look very much like the graph of the simpler model. The only difference will be that the consumption line will be lower. Increases or decreases in taxes will change the relationship between expected income and consumption.

The addition of government spending and taxes gives government a role in determining the level of national income. When government increases its spending by \$1.00, income rises by more than a dollar in this model because of the multiplier effect. When government increases taxes, expected disposable income decreases, and people reduce consumption. Through the multiplier process, national income falls by a multiple of the change in taxes. The use of changes in government spending or taxing with the goal of changing national income is called fiscal policy.

The multipliers for government spending and for taxes are not the same and the table above can help illustrate why they are not. As it stands, the equilibrium level of income is \$22,500, which results when expected disposable income is \$20,000. Suppose taxes are reduced to zero. What will happen to equilibrium income? The tax column becomes zero and expected disposable income would then equal expected income. We can then ignore the first two columns of the table and relabel the third column as expected income. Clearly the new equilibrium income will be \$30,000. Thus a reduction of taxes of \$2500 increases income by \$7500 (from \$22,500 to \$30,000), or each dollar of tax reduction increases actual income by 3.

Suppose instead that government spending increased by \$2500. Then the sixth column would have the value of \$4500, and actual income would be larger in each row. In particular, in the fourth row, actual income would increase to \$32,500. However, expected income in the fourth row is \$32,500, so this row contains the new equilibrium values. Hence an increase in government spending of \$2500 increases actual income by \$10,000 (from \$22,500 to \$32,500), or each dollar of increased government spending increases actual income by 4.

Changes in government spending and taxes both have the same effects on consumption in this table. Each dollar increase in government spending increases consumption spending by three as does each dollar decrease in taxes. The reason that they have different multiplier effects is that the change in government spending not only induces a change in consumption but also gets counted in spending, whereas the change in taxes does not get counted.

Having constructed the basic model, we next view it from some different perspectives.