GDP Measures Production

In our analysis here, we continue to focus on consumption and suppose that the other components of spending—government spending, investment, and net exports—are exogenous. That is, these variables are all unaffected by changes in income and so are all included in autonomous spending. In addition, we presume that the amount that the government spends is not affected by the amount that it receives in tax revenue. To find out the effects on the economy of a change in income taxes, we take the equation for real GDP and write it in terms of changes: change in real GDP = multiplier × change in autonomous spending. This equation tells us we need two pieces of information to work out the effect of a tax change:

1. The marginal propensity to spend because this allows us to calculate the multiplier 2. The effect of a tax change on autonomous spending

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Let us think about the marginal propensity to spend first. We want to know the answer to the following question: if GDP changes by some amount (say, $100), what will happen to spending? There are three pieces to the answer.

1. A change in GDP leads to a change in personal income. Remember from the circular flow of income that GDP measures production, income, and expenditure in the economy. Firms receive income when they sell their products. Most of that income finds its way into the hands of households in the form of wage and salary payments or dividend payments. Firms hold onto some of the income that they generate, however, to replace worn-out capital goods and finance new investments. In the early 1960s, personal income was about 78 percent of GDP. So if GDP increased by $100, we would expect personal income to increase by about $78.

2. A change in personal income leads in turn to a change in disposable income. As we explained at length, personal income is taxed, so disposable income is less than personal income. Since we are considering the effects of a change in taxes, we need an estimate of the marginal tax rate facing consumers. We know from Figure 12.3that this varied across individuals, but researchers have estimated that, for the economy as a whole, the marginal tax rate in 1964 was about 22 percent. [5] To put it another way, households would keep about 78 percent (= 100 percent – 22 percent) of their personal income. So if personal income increased by $78, disposable income would increase by about $61 (= 0.78 × $78). (It is a meaningless coincidence that these two numbers are both 78 percent.)

3. Finally, a change in disposable income leads to a change in consumption. According to the 1964 Economic Report of the President, the CEA thought that the marginal propensity to consume was about 0.93. So if disposable income increased by $61, we would expect consumption to increase by about $57 (= 0.93 × $61).