Question

What is a value-added tax (VAT), and what is an advantage of such a tax relative to an income tax? The following exercises are based on the appendix to this chapter. Answer exercises 11-14 on the basis of the following information. Assume that equilibrium real GDP is $\mathrm{\$}800$ billion, potential real GDP is $\mathrm{\$}900$ billion, the MPC is .80, and the $MPI$ is . 40 .

Short answer

Answer: Value Added Tax (VAT) is an indirect consumption tax imposed on the added value of a good or service at each stage of production and distribution. An advantage of VAT relative to income tax is that VAT can encourage saving and investment because it is based on consumption, while income tax is levied directly on income, regardless of what one chooses to do with that income.

Step-by-step solution

Understanding Value Added Tax (VAT) and its advantages

Value Added Tax (VAT) is an indirect consumption tax imposed on the added value of a good or service at each stage of production and distribution. This means that VAT is charged on the difference between the sale price and the purchase price of a good or service. The main idea is that the end consumer ultimately pays the tax, as the taxes paid by businesses at each stage are refunded. An advantage of VAT relative to an income tax is that VAT can encourage saving and investment since the former is based on consumption. People might be more likely to save and invest their income because they're only taxed when they consume goods or services, whereas income tax is levied directly on income, regardless of what one chooses to do with that income.

Exercise 11

First, we need to calculate the spending multiplier, which will help us understand the impact of an increase in government spending or a decrease in taxes on real GDP. Spending Multiplier = 1 / (1 - MPC + MPI) Replace the MPC (0.8) and MPI (0.4) values in the equation: Spending Multiplier = 1 / (1 - 0.8 + 0.4) = 1 / 0.6 = 1.67

Exercise 12

The next step is to determine the output gap – the difference between potential real GDP and equilibrium real GDP. Output Gap = Potential Real GDP - Equilibrium Real GDP Using the given values: Output Gap = $900 billion - $800 billion = $100 billion

Exercise 13

To close the output gap, we need to find the increase in government spending needed. We'll use the spending multiplier we calculated in Exercise 11 and the output gap from Exercise 12. Increase in Government Spending = Output Gap / Spending Multiplier Replace the values: Increase in Government Spending = $100 billion / 1.67 = $59.88 billion Thus, an increase of $59.88 billion in government spending is needed to close the output gap.

Exercise 14

Now, we will determine the decrease in taxes required to close the output gap. We'll again use the spending multiplier and the output gap. Decrease in Taxes = (Output Gap / Spending Multiplier) * (1 - MPC) Replace the values: Decrease in Taxes = ($100 billion / 1.67) * (1 - 0.8) = $59.88 billion * (1 - 0.8) = $11.98 billion Therefore, a decrease of $11.98 billion in taxes is required to close the output gap.

Key concepts

Consumption Tax

A consumption tax is a type of tax that is applied to the purchase of goods and services. Unlike an income tax, which is levied directly on earnings, a consumption tax is only charged when money is spent. This means only those who consume pay the tax. A key example of a consumption tax is the Value-Added Tax (VAT).

The idea behind consumption taxes is straightforward: people are charged based on what they use. This can be more efficient as it encourages saving and investment, thus potentially aiding in economic growth. Since individuals are taxed solely on their consumption, they might prefer to save their money rather than spending it, providing a balance between income expenditures and savings.

Furthermore, a consumption tax system could be seen as fairer by taxing consumption rather than earnings, as it allows individuals to have more say on when and how they are taxed. This can incentivize people to consume less and save more. It could also lead to more efficient allocation of resources as the taxation is related to spending rather than earning.

Spending Multiplier

The spending multiplier is an economic concept that helps us understand the effect of changes in government spending or tax policies on a country's output, namely the Gross Domestic Product (GDP). It shows how an initial change in spending can have a larger impact on the overall economy.

To calculate the spending multiplier, we use the formula:

• Spending Multiplier = $\frac{1}{1-\text{MPC}+\text{MPI}}$

MPC stands for the Marginal Propensity to Consume, which denotes the increase in consumer spending arising from an increase in disposable income.
MPI is the Marginal Propensity to Import, reflecting the additional amount spent on imports with an increase in income.

In the given exercise, with an MPC of 0.8 and an MPI of 0.4, the spending multiplier was calculated to be 1.67. This means that every dollar of government spending could potentially increase the real GDP by $1.67.

A higher spending multiplier generally indicates that fiscal policy changes can more effectively influence an economy's output. It does this by amplifying the effects of an initial change in spending, triggering a series of consumption and investment reactions.

Output Gap

The output gap is a measure of the difference between the actual output of an economy (equilibrium real GDP) and its potential output when operating at full capacity (potential real GDP).

When an economy produces less than its potential, it is said to have a negative output gap. This suggests underutilized resources and unemployed workers. Conversely, a positive output gap indicates that the economy is over-performing, producing more than its sustainable potential.

In this exercise, the output gap is calculated as:

• Output Gap = Potential Real GDP - Equilibrium Real GDP
• Output Gap = \(900 \text{ billion} - \)800 \text{ billion} = \(100 \text{ billion}

A negative gap of \)100 billion implies that the economy is underperforming compared to its potential. This information is essential for designing policy interventions. Such intervention might include increasing government spending or reducing taxes to boost economic activities.

Understanding the output gap allows policymakers to better gauge the state of an economy, making informed decisions to stabilize it back to its full potential, thereby promoting economic growth and reducing unemployment.