Question

Which of the following is not correct about the effect of taxes on income and output?

• A. Income taxes lower the multiplier effect
• B. Inclusion of taxes makes the aggregate demand curve steeper and hence increases the multiplier.
• C. Income taxes reduce the induced increase of consumption out of changes in income.
• D. Swings in investment demand have a smaller effect on output when automatic stabilizers such as proportional income tax are in place.

Hint:

Income taxes reduce the multiplier effect by reducing disposable income and consumption. Automatic stabilizers, like proportional income taxes, reduce the impact of investment swings on output.

Answer 1

The Correct Option is B

Step 1: Understanding the multiplier effect.
The multiplier effect refers to the proportionate change in national income resulting from an initial change in aggregate demand. Taxes reduce disposable income, thereby lowering consumption, which in turn reduces the multiplier effect.

Step 2: Analysis of options.
- (A) Income taxes lower the multiplier effect: This is correct. Higher income taxes reduce disposable income and therefore reduce consumption, which in turn lowers the multiplier effect.
- (B) Inclusion of taxes makes the aggregate demand curve steeper and hence increases the multiplier: This is incorrect. Taxes reduce disposable income, which flattens the aggregate demand curve, not steepens it. This reduces the multiplier, not increases it.
- (C) Income taxes reduce the induced increase of consumption out of changes in income: This is correct. Higher income taxes reduce the amount of disposable income and thus reduce consumption.
- (D) Swings in investment demand have a smaller effect on output when automatic stabilizers such as proportional income tax are in place: This is correct. Automatic stabilizers, like proportional taxes, help dampen the impact of swings in investment demand.

Step 3: Conclusion.
The incorrect statement is (B), as taxes reduce the multiplier effect and make the AD curve less steep.