Question

Given the Keynesian consumption function, how would a cut in income tax rates affect consumption? Explain your answer.

Short answer

A cut in income taxes increases disposable income, (Y-T), thereby leading to increased consumption according to the Keynesian consumption function. This is due to the marginal propensity to consume (c), which states that a portion of additional income will be used for consumption.

Step-by-step solution

Understand the Keynesian Consumption Function

The Keynesian consumption function can be written as C = C0 + c*(Y - T), where C represents consumption, C0 is the base level of consumption, c is the marginal propensity to consume, Y is income, and T is the amount of income tax. This equation demonstrates that consumption is directly related to disposable income, which is income after taxes, (Y-T).

Analyze the Impact of a Tax Cut

When income tax rates are cut, T is reduced. This means that (Y - T) increases, assuming income, Y, remains constant. This increase in disposable income will result in higher consumption, since according to the consumption function, an increase in disposable income leads to an increase in consumption.

Explain the Result

A tax cut increases disposable income (income after tax), which in turn increases consumption according to the Keynesian consumption function. This is because consumers have more income to spend, which they according to the theory partially use to increase consumption. This is represented in the equation by the marginal propensity to consume (c), a fraction of additional income that a household sector devotes to consumption.