Tax Cuts, Spending Multipliers and Economic Growth

October 10, 2012

Economic policy debates almost always center on how taxes and government spending affect the overall economy. One important factor to look at is the multiplier on government spending and the supply side effects associated with marginal tax rate reductions, says Economic Policies for the 21st Century.

The notion of a multiplier is essentially the ratio of government spending and investment relative to the increase in gross domestic product (GDP). For example, if the "multiplier" is 1, then $50 million in government investment would yield a $50 million increase in GDP. It is important that the government make these investments in order to utilize productive resources such as human and physical capital that would otherwise be idle.

The American Recovery and Reinvestment Act included major provisions that included a transfer of money from the government. It is important to look at the estimated multiplier effects of such investments to see whether the returns justify the expenditures. The following look at the high-end estimates for output multipliers of different activities the government engages in through the American Recovery and Reinvestment Act.

  • Extension of first-time homebuyer credit: 0.8.
  • One-year cut for higher-income people: 0.6.
  • One-time payment to retirees: 1.0.
  • Two-year tax cuts for lower and middle-income people: 1.5.

However, these multiplier effects don't take into account the hidden costs of government transfer of money. For example, transfers that simply give more money to people don't increase productivity because those people will be left without jobs.  Furthermore, government spending hurts private spending. Businesses may respond to federal deficit spending by preparing for future levels of taxation. This would cause them to save more and be more conservative with portfolios.

Deficit spending may yield high output multipliers; however empirical research shows that when debt comprises a large ration of the GDP, as it does in the United States, then deficit spending requires fiscal adjustments to pay back the debt and balance current spending levels. And as businesses spend less due to higher level of taxes, fiscal multipliers essentially go to zero as the government must spend in order to offset declines in private spending.

Source: "Tax Cuts, Spending Multipliers and Economic Growth," Economic Policies for the 21st Century, September 24, 2012.

 

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