Taxes

Allowing for taxes will of course, complicate our thinking in several ways, some of them less obvious than others. For example, we will have to distinguish between income before and after taxes. The term we use for income after taxes is "disposable income:"

Disposable Income: Disposable income is income net of taxes, and is the income the individual is able to divide between consumption and spending.

Thus, it is disposable income that we will use in the consumption function from now on. The consumption function will be

C = a + b(Y_d) = a + b(Y-T)

where T is taxes and Y_d is disposable income, while, as before, C is consumption, Y is income (before taxes) a is autonomous consumption and b is the marginal propensity to consume.

In model of this kind, taxes have only an indirect effect, by way of consumption. Consumption is determined by "disposable income."

For example, if the propensity to consume is 0.7, then $100 of additional taxation will reduce consumption expenditure by $70. This in turn will reduce equilibrium spending through a multiplier effect.

As usual, we will want to look at that in terms of the algebra and graphics of equilibrium. That's what we are here for.

Equilibrium with Taxes