Tax Multiplier

Plain definition

The number by which a change in taxes is multiplied to give the total change in GDP; equal to -MPC/(1-MPC), or equivalently -MPC/MPS.

In economics

The tax multiplier is negative because tax hikes reduce GDP and tax cuts raise it. It is smaller in absolute value than the spending multiplier: a $1 tax cut first passes through households, who save part of it (1-MPC), so only the MPC fraction enters spending in round one. Its size grows with the MPC.

Example

With an MPC of 0.8, the tax multiplier is -0.8/(1-0.8) = -4. A $50 billion tax cut raises GDP by about$ 200 billion (4 x 50), while an equal $50 billion spending increase with the spending multiplier of 5 would raise GDP by$ 250 billion, showing why spending packs more punch per dollar.

Common confusion

The tax multiplier is confused with the spending multiplier. Both come from the same MPC, but the tax multiplier is smaller because a tax cut leaks into saving before any spending occurs, whereas government spending enters aggregate demand in full immediately.