The marginal propensity to consume is that percentage of a change in a person's disposable income that would be consumed. If the income is not consumed, then it is saved. The calculation is to divide the incremental amount consumed by the incremental increase in personal income. The formula is:
Incremental amount consumed ÷ Incremental increase in personal income
For example, the government reduces the personal income tax rate by 5%. To estimate the impact that this will have on consumption within the country, the government's forecasters assume a 70% marginal propensity to consume. Thus, if the tax increase causes Mr. Smith to have an additional $1,000 of income, this will result in $700 of his new personal income being spent.
The marginal propensity to consume varies by income level. It tends to be quite high among lower-income groups, since these people need to spend everything just to have adequate food, clothing, and shelter. As the income level increases, people tend to have less need to buy more, and so will save a high proportion of all incremental income earned.
The concept is used when deciding how to set tax rates. The theory is that a decline in tax rates will increase spending, which in turn raises income, so that people will pay more taxes. When the concept works, it means that everyone earns more money, while the government still earns enough taxes to cover its operations.