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So T stands for income taxes imposed on households. t stand respectively for national income, consumption, private investment, government expenditure, tax rate, and a and b are parameters.Such taxes reduce the disposable income of the people, as the following example will show. From equation (i)—(iii) we get Y = a b(Y – T) I G = a b Y (l — t) I G Or, Y a I G/1-b(1-t) Therefore, dy/dt = -(a I G) b/[1-b(1-t) G (36.3) The last point is very important here.Thus in terms of equation (36.3) which defines national income equilibrium we get: S G or. We also observe that this equilibrium level of national income is achieved with a government budget deficit of Rs.
These basic propositions have to be borne in mind when discussing the role of government in the circular flow of income.
We may now integrate these propositions into the general analysis of national income determination.
On the other hand an exactly opposite type of fiscal action is called for when the economy is in deep depression.
So the government has to reduce taxes and/or increase its own spending.
These will have the effect of increasing the flow of spending and enlarging aggregate demand.
Such measures become absolutely essential when unemployment threatens to increase and the economy needs a stimulus.As a result the equation for the uses of the national income becomes: Y = C S T where T stands for taxes paid to the government.Here we ignore indirect taxes as also corporate taxes.Problem 1: Assume that consumption is a linear function of ‘disposable’ income and realised taxes are a linear function of realised national income. It highlights the fact that desired savings do not have to equal desired investment in order for a given level of national income to be maintained. The leakages- injections approach would now tell us that aggregate demand would continue to fall until the two were brought into equality.With exogenously given government expenditure and private investment how can you establish a relationship between a change in the tax rate and a change in national income? Like the injections (plans) and expectations of the private sector, government spending and taxes are very important condition of national income equilibrium: The national income can be sustained (or maintained) at a level at which desired savings substantially exceed desired investment, as long as government expenditure exceeds tax revenues by the same amount. Let us suppose the economy is in a situation in which desired saving equals Rs. But the decline need not necessarily occur: if government expenditure is Rs. 85 crore, the gap would be covered and a sustainable level of national income achieved. Since leakages from the flow of spending (the left hand side of the equation) are equal to injections into the flow (the right hand side of the equation), and the desires of both savers and investors are realized, a sustainable level of national income is achieved.Of course, there is controversy among economists regarding the optimal level of government intervention in the economy.However, the fact remains that government expenditure and taxation programmes exert considerable influence on national income, output and other key macro-economic variables.Taxes reduce aggregate demand by reducing disposable income of the community. Government expenditure on goods and services produced in the private sector add to aggregate demand by channelling purchasing power back into the flow of spending.It logically follows from these two basic principles that economic activity can be slowed down by raising taxes and/or reducing government expenditures.Government and the Determination of the National Income (Product): When we consider government spending a new factor is added to the determinants of aggregate demand.Government purchases of goods and services will now add to consumption and investment spending in determining the level of national product and income.