Question

Suppose that the government decreases lump-sum taxes. What are the effects of this on the consumer’s optimal choice? (Determine how consumer’s optimal C and l change.)

Answer 1

When government decrease the tax, then it increases the disposable income for the consumers. Now consumers increase their consumption on the basis of marginal propensity to consume (MPC). Further, some of the income will also be saved by the consumer on the basis of marginal propensity to save (MPS). The savings will be supplied in the capital market, or banks or in the market of loanable funds and investment will increase.

Here,

MPC + MPS = 1

MPC = Increase in consumption / Increase in income

MPS = increase in savings /increase in income

So, consumption increases on the basis of MPC and investment increases on the basis of MPS when disposable income increases.