The government has to raise revenue resources to meet out its expenditure. Tax is the most important source of government revenue. Tax is a leakage from the national income. Tax payments reduce the disposable income of the individuals. Tax should be considered as negative transfer payments in their effect on desired aggregate spending.

Thus far, we have discussed the impact of government spending n equilibrium level of income. We shall now show the effect of taxes on the equilibrium level of income.

The impact of taxes on the economy is felt via consumption. Consumption spending of the individuals depends upon their disposable income. Personal disposable income is obtained by subtracting taxes from personal income.

                Yd = Y-T
Where     Yd = Personal disposable income,
                 Y = personal income, and
                  T = tax

For simplifying our analysis we assume that the amount of tax remains constant irrespective of the level of income. With the introduction of taxes the model presented above takes the following form:

                      C = a + bYd             Consumption function
Where          Yd = Y-T
                       I = I₀                         investment spending
                       G = G₀                    government spending
                        T = T₀                     Taxes

The necessary condition of national income equilibrium is that aggregate output (GDP) should be equal to desired aggregate spending, that is
                           
    Y = C + I +G

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