Explain Tax rate increase.

A change in tax rate changes the IS equation, LM equation remaining the same. Let same, let us suppose that the government raises the tax rate from 20 percent to 25 percent. The rise in tax rate from t = 0.20 to t = 0.25 would change the IS equation by changing the consumption function with increase in tax rate, the consumption function changes form C = 100 + 100 + 0.60 Y, given in Eq. to 

C= 100 + 0.75 [Y - (40 + 0.25Y + 40)]

= 100 + 0.5625Y


With change in the consumption function, the new IS schedule (say, IS2) can be obtained as follows. 

IS2 schedule: 

Y = C + I + G + ?G

= 100 + 0.5625Y + 250 - 4i +200

= 1257.14 - 9.14i


Given the new IS function (IS2) in Eq. the new equilibrium interest rate can be worked out as follows.

Is2 = LM

1257.14 - 9.14i = 800 + 80i

89.14i = 457.14

I = 5.13 (percent)

Once interest rate is known equilibrium income with tax effect can be computed by substituting the interest rate (5.13%) into the IS2 or LM equation. By using IS2 function, we get

Y = 1257.14 - 9.14i = 1257.14 - 9.14 (5.13)

The negative effect of increase in tax rate on the equilibrium income equals income before tax - rise less income after tax-rise that is

Tax effect = $1311.10 bn - $1210.25 bn

$100.85 billion

This calculation shows that increasing tax rate form t = 0.20 to I = 0.25 decreases equilibrium income by $100.85 billion

   Related Questions in Macroeconomics

  • Q : Estimating rational income How will you

    How will you treat the given in estimating rational income of India? Provide reasons for your answer. (i) The value of bonus shares received by the shareholders of a company.(ii) Interest received on loan pro

  • Q : Macro economics policy (a) Do you think

    (a) Do you think that macroeconomic policy should be designed to achieve a measured unemployment rate of zero? Why or why not should this be the case?

  • Q : Equilibrium The equilibrium interest

    The equilibrium interest rate is determined

  • Q : Supply of foreign currencies into

    What are the main sources of supply of foreign currencies into domestic economy? Answer: A) Foreigners purchasing home country’s goods and services via exports. B) Foreign investment in home country via

  • Q : Help The demand for a resource will

    The demand for a resource will increase if the

  • Q : Discount rate-Prime rate and the

    What is the difference among the discount rate, prime rate and the subprime rates of interest? Which interest rate in particular build the 2008 recession? Explain how that happened.

  • Q : About macroeconomics Do you think that

    Do you think that macroeconomic policy should be designed to achieve a measured unemployment rate of zero? Why or why not should this be the case?

  • Q : Problem on full employment level of

    What happens when AD > AS past to full employment level of employment?

  • Q : Limitations of using GDP as an index of

    What are the limitations of using GDP as an index of welfare of a country?A) The N.I. figures provide no indication of the population, skill and resource of the country. Thus the levels of welfare stay low.B) A higher N.I. migh

  • Q : Determine the marginal propensity to

    If disposable income increases from Rs. 1,000 to Rs. 1,100, savings increase by Rs. 30. Determine the marginal propensity to save and marginal propensity to consume?

©TutorsGlobe All rights reserved 2022-2023.