Which factor helps explain why spending multipliers are larger than tax multipliers?

• A. Tax cuts are always saved completely.
• B. Spending directly adds to aggregate demand, while part of tax cuts may be saved.
• C. Taxes have no effect on consumption.
• D. Tax cuts always increase imports.

Answer: (B)

The main idea here is how changes in policy translate into spending and, in turn, into GDP. Spending increases add directly to aggregate demand, so the full amount of the change supports more production. A tax cut, however, raises households’ disposable income, and people don’t spend all of that extra income—part is saved. That means the impulse to aggregate demand is smaller for a tax cut than for an equal-sized increase in government spending.

In a simple framework with a given marginal propensity to consume (MPC), the spending multiplier is 1/(1 − MPC), while the tax multiplier is −MPC/(1 − MPC). Since MPC is between 0 and 1, the spending multiplier has a larger magnitude than the tax multiplier. For example, with MPC = 0.8, the spending multiplier is 5, but the tax multiplier is −4, illustrating why spending changes tend to have bigger effects.

The other statements aren’t correct because tax cuts aren’t saved completely, taxes do affect consumption through disposable income, and the idea that tax cuts always raise imports isn’t a defining reason for the difference in magnitudes.