Effect of Changes in Taxes, Subsidy and Government Expenditure on Equilibrium Income is discussed.

1. IMPACT OF GOVERNMENT
EXPENDITURE AND TAXES
ON INCOME
DR. LAXMI NARAYAN
ASSISTANT PROFESSOR OF ECONOMICS
GOVT. P.G. COLLEGE MAHENDERGARH

2. Lecture Outline
 Fiscal policy: Rational and
Instruments
 Government expenditure and
tax function.
 Determination of National
Income in a Three Sector
Economy.
 Impact of Changes in
Government Expenditure and
Tax Rate on Equilibrium GDP

3. Govt. Expenditure and
Taxes: Instruments of
Fiscal Policy
Govt. Expenditure Policy: .Expenditure for buying goods and
services and for transfer payments.
Other instruments are fiscal policy are Public Debt Policy
and Deficit Financing
Taxation Policy: Govt. uses
taxes for affecting real
purchase power for desired
policy outcomes.

4. Why Fiscal Policy?
 Growth with Full Employment
 Price Stability
 Reduction in Economic
inequalities
 Fiscal policy can be expansionary or contractionary.
 Expansionary fiscal policy increases the output, or
national income, while contractionary fiscal policy
decreases the output, or national income.

5. Government
Expenditure Function
 The government expenditure
function shows the relationship
between govt. expenditure and
GDP.
0 200
Government.Exp.(G)
Govt. expenditure
is constant at any
level of GDP
Real GDP
(Rs. Crore)
G. Exp
(Rs. Crore)
0 100
200 100
300 100
500 100
300 500
Real GDP(Y)
G = 100
G is autonomously fixed according
to Government Budget Policy for
each year.

6. Government Tax
Function
0
40
TaxRevenue(T)
Real GDP
(Rs. Crore)
Tax Rate
(%)
G. Exp
(Rs. Crore)
0 20 00
200 20 40
500 20 100
900 20 180
500 900
Real GDP(Y)
200
100
180
T=f(Y)

7. Budget Surplus(Public
Saving) Function(T-G)
0
-60
BudgetSurplus(T-G)
Y G T T-G
0 100 00 -100
200 100 40 -60
500 100 100 0
900 100 180 80
1500 100 300 200500 900
Real GDP(Y)
200
80
200
T-G = f(Y)
-100
1500

8. Domestic Saving Function (S + T-G)
0
Saving(T-G)
Real GDP(Y)
Sd = S+(T-G) = f(Y)

9. Equilibrium GDP
Determination
Equilibrium will occur when
there is no tendency for an
economy to change.
There are two alternate
approaches:
Total Approach: Equilibrium may occur when planned
aggregate expenditure(AE) is equivalent to aggregate
output(Y) that is AE = Y
Leakage Injection Approach: Equilibrium also can be
determined when: INJECTION = LEAKAGE

10. Total Approach
(AE=Y)
Aggregate Expenditure (AE)
AE is the sum of desired
consumption, desired investment
and government expenditure.
Symbolically: AE = C+I+G
C = a + b Yd, where a is autonomous consumption (fixed
irrespective of the income earned) and bYd is an amount that
depends on the disposable income and b=MPC.
I = Public Investment Expenditure (independent of GDP)
G = Government Expenditure (independent of level of GDP)

11. Total Approach
(AE=Y)
Aggregate Output (Y)
Aggregate output is the sum of
consumption, savings and Taxes.
Symbolically: Y = C+S+T
Aggregate output(Y) is a 45o
line from the origin. Each
point on the 45o
line shows the equality between
desired aggregate output and desired AE.

12. Aggregate Expenditure and Aggregate Output
Real
GDP
Y
Desired
Consumption
Expenditure
C = 75+0.75Y
Desired
Investment
Expenditure
I = 200
Desired
Government
Expenditure
G = 100
Aggregate
Expenditure
AE=C+I+G
0 75 200 100 375
200 225 200 100 575
400 375 200 100 675
500 450 200 100 750
800 675 200 100 975
1500 1200 200 100 1500
2000 1575 200 100 1875
2500 1950 200 100 2250
3000 2325 200 100 2625
AE>Y
AE<Y
AE=Y

13. Aggregate Expenditure
0
Real GDP (Y)
Aggregate.Expenditure
Aggregate Expenditure = C+I+G

14. Impact of Change in Government Expenditure on
Aggregate Expenditure
0
Real GDP (Y)
Aggregate.Expenditure
C+I+G

15. Y = C+S+T
45
Aggregate Output(Y)
Real GDP (Y)
Aggregate.Expenditure
C+I+G
Y
A 45 line is drawn from the
origin showing equality
between desired output and
desired AE.
Each point on the 45 shows
the equality between AE and
GDP.
Y = C+S+T Y-T = C+S Yd = C+S
Yd is the spendable income of the people.

16. Y = AE
45
Determination of Aggregate Income
Real GDP (Y)
Aggregate.Expenditure(AE)
A 45 line is drawn
from the origin
showing equality
between desired
output and desired
AE.
Each point on the 45
shows the equality
between AE and GDP.
E
YE

17. Total Approach(Income – Exp. Approach)
Y=AE
Y
AE
0
AE=C+I+G
Ye Y1Y2
Production
At Y2, Y < AE
Unplanned
decrease in
inventories
}
{
Determination of Aggregate Income
E

18. Withdrawal
Equilibrium income (or equilibrium GNP) is
reached when Y = AE
Injection=
Injection- Withdrawal (Saving-Investment) Approach
C + S + T = C + I + G
S + T = I + G
Now S + T = I + G
I = S+T- G
I = Sd
=Injection Withdrawal

19. Diagrammatic Representation
Injection- Withdrawal (Saving-Investment) Approach
At Y1, J < W
 unintended
inventory
investment
At Y2, J > W
 unintended
inventory
disinvestment
Y
AE
0
I0
Sd = S+(T- G)
I0
Ye Y1Y2
{
}
Production
E
Production

20. We know AE = C + I + G
and C=a+bY
Estimating Equation
Putting the value of C
AE = a+bY+I+G
At Equilibrium AE=Y, thus
Y = a+bY+I+G  Y - bY= a+I+G  Y (1-b)= a+I+G
Investment Multiplier
b = MPC
Equilibrium GDP

21. We know AE = C + I + G
and C=a+b(Y-T)
Equilibrium GDP with
Lump sum Tax
Putting the value of C
AE = a+b(Y-T)+I+G
At Equilibrium AE=Y, thus
Y = a+bY-bT+I+G  Y-bY= a-bT+I+G  Y (1-b)= a-bT+I+G
Investment Multiplier
b = MPC
Equilibrium GDP
with Lump Sum Tax
Y =
1
1-b
(a-bT+I+G)

22. We know AE = C + I + G
and C=a+b(Y-tY)
Equilibrium GDP with
Proportionate Tax
Putting the value of C
AE = a+b(Y-tY)+I+G
At Equilibrium AE=Y, thus Y = a+bY-btY+I+G
Y-bY+btY = a+I+G  Y(1-b+bt)= a-bT+I+G  Y [1-b(1-t)]= a+I+G
Investment Multiplier
b = MPC
Equilibrium GDP
with Lump Sum Tax
Y =
1
[1-b(1-t)]
(a+I+G)

23. Real GDP (Y)
E
I I0
Sd
Sd
Ye
S&I
Panel-(B)
Y1
Real GDP (Y)
E
0 Ye
Agg.Exp.
Y=AE
45
Panel-(A)
Y1 Y2
Y2
0
Diagrammatic Representations of Two Approaches
At OYe - Equilibrium
Y=AE in panel (A)
and Sd =II0 in Panel (B)
At OY1 - Disequilibrium
AE>Y in panel (A)
and II0 > Sd in Panel (B)
At OY2 - Disequilibrium
AE<Y in panel (A)
and II0 < Sd in Panel (B)

24. Impact of Change in G on Equilibrium GDP
We know Y = a+b(Y-tY) + I + G……………(i)
Now suppose govt. increase its expenditure by G
and as a result of this income increases to Y1we have :
Y1= a + b(Y1-tY1) + I + G + G ………(ii)
Subtracting eq (ii) from Eq (i), we have:
Or Y1 -Y = b[(Y1-Y) –t (Y1-Y)] +G
Y1 -Y= [a –a] + [b(Y1-tY1)- b(Y-tY)]+ [I-I] + [G-G] + G
Let Y1 –Y = Y
Then Y = b[Y - tY]+ G

25. Impact of Change in G on Equilibrium GDP
From the previous slide, we have
Y = b[Y - tY]+ G
or Y - bY +b tY =G
or Y[1 - b + bt] =G
or Y = 1 . G
[1 - b + bt]
Y 1
[1 - b + bt]=G
Y 1
[1 - b (1-t)]=G
or
or Kg = = Govt. Multiplier

26. Real GDP (Y)
E
0
Ye
AggregateExp.
Y=AE
45 Y1
Impact of Change in G on Equilibrium GDP
E1
Govt. MultiplierChange in GDP = x
Y
1
1 - b (1-t)= G
Change in G

27. Impact of Change in G on Equilibrium GDP
Govt. MultiplierChange in GDP = x
Y
1
1 - b (1-t)= . G
Change in G
We know that:
Sd= S+T-G
Increase in G would
reduce the domestic
savings and would
shift Sd curve to the
right increasing
income from OYe to
OY1.
Y1
E1
Sd-G

28. Impact of Change in T(Tax Collection)
on Equilibrium GDP
We know Y = a+b(Y-T) + I + G……………(i)
Now suppose Tax collection increases by T and as
a result of this income decreases to Y1we have :
Y1= a + b(Y1-T-T) + I + G ….………(ii)
Subtracting eq (ii) from Eq (i), we have:
Or Y1 -Y = b[(Y1-Y)] –b (T)]
Y1 -Y= [a –a] + [b(Y1-T-T)- b(Y-T)]+ [I-I] + [G-G]
Let Y1 –Y = Y
Then Y = bY - bT

29. Impact of Change in T(Tax Collection)
on Equilibrium GDP
From the previous slide, we have
Y = bY - bT
Y - bY = -bT
Y (1- b) = -bT
or Y =
[1 – b ]
1
-bT
or Y -b
(1 – b)
=T

30. Real GDP (Y)
E
0
Ye
AggregateExp.
Y=AE
45 Y1
E1
Impact of Change in T(Tax Collection)
on Equilibrium GDP
Exp. MultiplierChange in GDP = x
Y
-b
1 – b= T
Change in T

31. We know that:
Sd= S+T-G
Increase in T would
increase the
domestic savings
and would shift Sd
curve to the left
decreasing income
from OYe to OY1.GDP (Y)
I I0
Sd
Sd
Ye
Saving&Investment
0 Y1
E1
E
MultiplierChange in GDP = x
Y
-b
1 – b= T
Change in T
Impact of Change in T(Tax Collection)
on Equilibrium GDP

32. Jain, T.R and Majhi, B.D.,
“Macroeconomics” V.K.
Publications.
Rana, K.C. and Verma,
K.N., “Macro Economic
Analysis” Vishaal
Publications.
Rana, A.S., “Advance Macro Economics-Theory and
Policy,” Kalyani Publishers.
Shapiro, E, “Macro Economic Analysis” Galgotia
Publications.
REFERENCES

33. Discuss the effect of change in
the government expenditure
on equilibrium real GDP.
 Discuss the impact of changes
in tax rate on the equilibrium
GDP.
 Why there is a parallel shift in Aggregate Expenditure function
when government expenditure changes and non parallel shift
when tax rate changes.
 Explain the determination of National income in a three sector
economy.
FAQs