Suppose the government decreases taxes. What is the most likely effect on disposable income and consumer spending?

• A. Disposable income will decrease, but consumer spending will increase.
• B. Disposable income will decrease, leading to lower consumer spending.
• C. Disposable income will remain unchanged, but consumer spending will decrease.
• D. Disposable income will increase, leading to higher consumer spending.

Answer: (D)

Verified step by step guidance

1. Understand the concept of disposable income, which is the amount of income households have left after paying taxes. It is calculated as: \(\text{Disposable Income} = \text{Total Income} - \text{Taxes}\).
2. Recognize that when the government decreases taxes, the amount subtracted from total income is smaller, so disposable income increases.
3. Recall the relationship between disposable income and consumer spending: generally, as disposable income increases, consumers have more money to spend, leading to higher consumer spending.
4. Consider the marginal propensity to consume (MPC), which measures the fraction of additional disposable income that households spend on consumption. Since MPC is positive, an increase in disposable income results in increased consumer spending.
5. Conclude that a decrease in taxes leads to an increase in disposable income, which in turn leads to higher consumer spending.