In economics, there will always be a need to calculate tax and taxation. Tax paid by citizens and business owners in a country will not remain the same over time.

However, it is your duty as a student to be aware of the changes in taxation. You also need to take note of the cause and the effect on the economy. Tax and taxation are prominent topics in economics, and you have to understand the concept and be able to solve questions as regards the subject.

In this article, we will be explaining the tax multiplier and tax multiplier formulas with examples.

What is a Tax multiplier?

A tax multiplier is a measure of change in the gross domestic product of a nation as a response to a change in the taxes charged by the government. In other words, it is a means of numerically measuring the level of impact a change in taxation would have on the nation’s economy. 

You should know that tax multiplier can be straightforward if the taxation change affects the citizens’ consumption level. However, it becomes a different ball game of complexity if the taxation change impacts all the components of the nation’s GDP.

It is not enough for the government to just make a policy on taxes and macroeconomic components without first considering the economic impact of such policies and the best ways to mitigate the effects of a tax increase. 

Effects of Government increasing and decreasing tax.

For example, if the government increases a company’s tax, it translates to a higher cost of operation. This directly means there will be either an increase in the price of products or a reduction in the quantity and quality of the product. It is a response to the increased tax. 

The consumer will also experience an increased cost of living and lower purchasing power. In response to this situation, the consumer might decide to cut down his expenses or take on more work as an entrepreneur or producer.

Another scenario that can happen is a decrease in tax. If, for example, the government decreases tax by some percentage, say 6.2%, there will be a decrease in the cost of production and a more significant net profit.

This means that the citizens would have more money in hand to spend. The rate of consumption and purchasing power would most likely increase. The people would be able to save more and invest more.

This could also mean inflation is lurking around or not if well managed. An increase in the consumption rate of the citizens would mean an increased production rate to meet the market demand. This would, in return, improve the nation’s gross domestic product for the year.

This gives a brief insight and explains the spiral effect of change in taxation on the finance of citizens and the national economy at large.

How can we predict and calculate tax multipliers?

You should know that these changes can be predicted and calculated. Hence, the need for you to be adequately schooled in economics and understand tax multipliers. This will help you function nicely as an economist in the country. 

A tax multiplier is a formula that you can use to calculate the impact of change caused by tax policies on the production level and consumption levels of a country. A country’s GDP is the aggregate of its annual production and consumption.

You should also take note that GDP and taxes have an inverse relationship. A tax increase will lead to a reduced GDP, while a decrease in tax will boost the nation’s GDP.

What Is The Tax Multiplier Formula? 

The tax multiplier formula is the specific set of information that you need to consider and analyze to calculate a tax multiplier.

There are two ways to calculate tax multiplier, i.e., two tax multiplier formulas. There is a basic one, and there is a complex one. 

The basic formula calculates the tax multiplier when the effect of the tax change is seen only in the nation’s consumption rate. On the other hand, we use the complex formula when we have to consider all the components of the gross domestic product as affected by the change in tax.

Basic Tax Multiplier Formula 

The only required information is MPS – Marginal Propensity to Save and MPC – Marginal Propensity to Consume.

To understand this better, consider a man earning $400. His tax rate will be reduced from 20% to 10%. This means he had only $320 to spend before, but now, he has $360 to himself.

If he spends $270 and saves $90, his MPS and MPC would be  0.75(75%) and 0.25(25%), respectively.

Take note that MPC and MPS must always add up to 1 or 100% expressed in percentage. You can express them in the form of each other, i.e.

MPS = 1 – MPC.

Now, you can calculate the tax multiplier as follows:

 – MPC/MPS

The negative sign there is to show the inverse relationship between taxes and GDP. On its own, the tax multiplier will give a negative answer.

You can also write out the basic tax multiplier formula as: 

–MPC

1 – MPC

Remember that MPS = 1 – MPC.

That is all you need to calculate the tax multiplier using the basic formula.

Complex Tax Multiplier Formula 

Here, we consider not only the Marginal Propensity to Consume, MPC, and Marginal Propensity to Save but all components of the nation’s gross Domestic Product and GDP.

When there is a change in tax policies, it can influence virtually everything that makes up the nation’s economy. This is because it indirectly controls the amount of money that flows through the hands of the citizens, and their consumer behavior is triggered to either increase or decrease production, either increase or decrease investment.

The basic formula considers only the consumption rate of citizens, while this will consider all components of the GDP. 

The other components considered in complex Tax Multiplier are: 

MPI – marginal propensity to invest

MPM- marginal propensity to import

MPT – the marginal propensity to tax

MPG – marginal propensity for purchases (government)

MPC – marginal propensity to consume

The complex Tax Multiplier Formula is:

Tax Multiplier = – MPC / [1 − (MPC × (1 − MPT) + MPI + MPG + MPM)]

Importance of Tax Multiplier Formula 

Taxes are indispensable when it comes to the economic status of a nation. Studying and understanding the concept of tax and its implications is a worthwhile prospect from a financial view. 

The tax multiplier is one of many factors considered in making decisions concerning an increase or decrease in tax. However, the formula captures the tax policy’s effect on the nation’s GDP.

It is interesting to be aware of the economic implications of the decisions people in government make concerning taxes. Tax Multiplier Formula will give you the necessary knowledge to understand taxes in micro and macroeconomics.

How can CEAnswer help you with Tax Multiplier Calculations?

In conclusion, we have discussed the relationship between taxes and GDP and the various forms of calculating tax multipliers. If you have further issues and need professional help, you can contact us at the CEAnswer website. We are committed to helping students with academic problems and providing professional support when needed.