THE THEORY OF FISCAL POLICY

Fiscal policy is the use of government spending, taxing, and borrowing to increase or decrease aggregate demand. Aggregate demand is the sum of private spending on consumption and investment and government spending (g.n.p. = C + I + GE). The government can increase total expenditures by spending more than it currently takes away from private spending in taxes. Conversely, when total private spending is too high, the government can reduce g.n.p. by taxing away more than it spends. Either way, the net change in autonomous spending triggers a multiplier effect.

Look back at the circular flow diagram of Fig. 4-2. The government may spend back more into the income stream than it currently withdraws from it, thus swelling the total. Or it may spend back less, thus reducing the flow of total spending. Obviously the net result depends on the expansionary effect of government spending offset against the depressive effect of tax collections.

An increase in government expenditures raises g.n.p. The increase per dollar of government spending is determined by the multiplier. Each additional dollar of government spending on goods and services adds directly to g.n.p. and becomes income to an individual or a business. Part of this new income will be respent, in the familiar multiplier-respending process of Chapter 6. If the multiplier for the economy is 2, for example, each dollar of additional government spending will generate an increase of $2 in g.n.p.

An increase in tax collections reduces g.n.p. The decrease per dollar of tax collections again depends on the multiplier. When individuals or businesses pay taxes out of their incomes, they reduce their spending on goods and services. This reduction has a negative multiplier effect, the reverse of the positive multiplier associated with government expenditures. The size of this negative multiplier will depend on much the same factors as those determining the positive multiplier on government spending, as was explained in Chapter 6.

The net multiplier effect of the government budget on the economy depends on the net result of these plus and minus multipliers. The larger the excess of government expenditures over tax receipts (i.e., the larger the deficit), the stronger will be the expansionary effect of governmental fiscal policy, other things equal. Conversely, the larger the excess of tax receipts over expenditures (i.e., the larger the government surplus), the more deflationary government fiscal policy will be. These propositions will need to be qualified somewhat presently, but they provide a powerful first approximation. When we want the government to exert strong expansionary pressure on g.n.p., a substantial government deficit is desirable.

FIG. 13-1 Net new government spending of 10 adds 10
of “investment” and, with a multiplier of 4, raises total in-
come by 40—up to a new equilibrium of 390. This is
identical with the multiplier effect of 10 of new private
investment in Fig. 6-4.

Figure 13-1 presents the analysis graphically. Let the CC and C + I lines be identical with the lines in Fig. 6-4, back on page 67. Equilibrium income would then be 350, where C + I cuts the 45ฐ line. Now suppose the government enters the picture and begins to spend 10 each year without collecting any taxes (perhaps borrowing at the banks). We can thus draw a new government spending layer (GE) on top of the C + I curve. This new C + I + CE curve is 10 higher at every point. As indicated above, the new government spending becomes income to the private economy and has a multiplier effect just like private investment. If the marginal propensity to consume is .75, the new equilibrium level of g.n.p. in Fig. 13-1 will be 390, as the multiplier raises total income by four times the original government spending. Note that this new equilibrium income is identical to that in Fig. 6-4, where the additional autonomous spending of 10 was private rather than govern-
ment.

The Balanced-Budget Multiplier

It may appear intuitively that a balanced government budget (i.e., tax collections just equal to government spending) will always be neutral in its effect on g.n.p. But this is not quite correct. An increase in government spending matched by an identical increase in tax collections provides some net expansionary multiplier effect, and a decrease in government expenditures exactly matched by tax reduction has a net deflationary multiplier effect. This is called the “balancedbudget multiplier.” It works this way.

Assume that the government increases its spending by $10 million, and that the public’s marginal propensity to consume is .5. Disregard any accelerator effects. The $10 million of new government spending immediately constitutes $10 million of new g.n.p., to which the multiplier adds another $10 million through respending. This gives a total increase in g.n.p. of $20 million in the new equilibrium level of g.n.p.

Now trace through the deflationary impact of the $10 million of new taxes to finance the expenditures. With a marginal propensity to consume of .5, private spending will fall by $5 million in the first round, $2.5 million in the secqnd, $1.25 million in the third, and so on as in the preceding example. The total sequence of respending rounds ($5 million plus $2.5 million plus $1.25 million plus. . . .) adds up to a total negative multiplied effect of $10 million for the tax increase.

Note that this negative tax multiplier is just $10 million less than the positive expenditure multiplier, just the amount of the budget increase. The respending effects after the first impact of the new government spending and of the new government taxes are the same, but the $10 million increase in government purchases of goods and services became a direct part of g.n.p. whereas the tax payment by the private economy to the government was simply a transfer of purchasing power which is not part of g.n.p. The “balancedbudget multiplier” is thus just 1 in this example; g.n.p. rises by precisely the amount of the increase in government spending financed by an identical increase in government tax receipts. The $20 million addition to g.n.p. exceeds the $10 million reduction by just the amount of the new government spending.

Most economists agree that a balancedbudget multiplier effect of this sort occurs. But it need not be precisely . This precise result depends on two assumptions: that the propensities to consume of taxpayers and of those who receive income from government spending are identical; and that the government spending is on goods and services rather than on transfer payments. These assumptions may not be met. Moreover, the balanced-budget multiplier is, at best, only 1. Most economists believe that deficit-financed government spending is a far surer road to a higher g.n.p.