A while back, I wrote about the relative size of the government spending and tax multipliers. After spending way too long on IS-LM models in my macro class and thinking some more about fiscal multipliers, I'm now convinced that government spending multipliers can not be as large as the multiplier on tax cuts and think I can more clearly explain why.
As one of my students suggested, government spending is at a fundamental disadvantage, since it must predict where money is best directed. That is, government spending, at best, will allocate resources in the way the individuals and firms would choose to. Once one admits this, then it's clear that the only advantage that government spending has over tax cuts (and why the multiplier is larger on government spending in a very simple IS-LM model) is because $1 of government spending increases aggregate expenditures by $1, where as $1 in tax cuts only increases aggregate expenditures by $1 times the "marginal propensity to consume". And since the marginal propensity to consume is less than one, the government spending multiplier is higher than the multiplier on tax cuts.
Thus, for a tax multiplier to be as high as the government spending multiplier in this simple framework, one only needs to think of tax cuts that are available only to those who spend the entire value of the tax cut. One idea is to cut sales taxes. Another is to offer an investment tax credit.
All tax cuts are not the same. Cutting income taxes does not increase aggregate expenditures dollar for dollar- people will save some of this tax cut. So when we go out and measure these multipliers, we have to be more careful in our analysis than looking at the changes in total government expenditures or total government tax revenue and the subsequent effects on GDP (as most do). Just as the spending multiplier is different for government spending on different goods and services, so to is the tax multiplier different for different tax cuts.
Thus, for a tax multiplier to be as high as the government spending multiplier in this simple framework, one only needs to think of tax cuts that are available only to those who spend the entire value of the tax cut. One idea is to cut sales taxes. Another is to offer an investment tax credit.
All tax cuts are not the same. Cutting income taxes does not increase aggregate expenditures dollar for dollar- people will save some of this tax cut. So when we go out and measure these multipliers, we have to be more careful in our analysis than looking at the changes in total government expenditures or total government tax revenue and the subsequent effects on GDP (as most do). Just as the spending multiplier is different for government spending on different goods and services, so to is the tax multiplier different for different tax cuts.
