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 \(\$ 800\) billion, potential real GDP is \(\$ 900\) billion, the MPC is .80, and the \(M P I\) 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.