Contents
The balanced budget multiplier focuses specifically on the impact of government spending and taxes when they are adjusted at the same rate. It might seem counterintuitive, but even when the government maintains a balanced budget (revenue equals spending), changes in these components can still significantly affect the overall level of economic activity, measured by Gross Domestic Product (GDP). This concept is particularly relevant in a closed economy, where there are no imports or exports to complicate the picture. Here, we’ll explore how the balanced budget multiplier works, why changes in spending can have a more significant impact than changes in taxes, and some of the limitations of this model in real-world scenarios.
Understanding the balanced budget multiplier
In economics, a multiplier means that when a factor changes, it influences other economic variables more broadly. For example, in a fiscal multiplier, government spending increases X times; it will increase aggregate output more than X times.
Another example is the money multiplier. When the central bank reduces the reserve requirement ratio, say from 10% to 5%, it multiplies the money supply in the economy by 20 = 1/5%. So, if the bank lends one rupiah and circulates it in the economy, it will become $20.
A balanced budget means revenue equals expenditure. Because most of the government revenue comes from taxes, many economists write them down as tax revenue equals expenditure.
Spending that is greater than income means a deficit. Conversely, spending smaller than income means a surplus.
Some economists argue that switching from a budget deficit to a balanced budget contributes positively to lower interest rates and increased investment. The shift also shrinks trade deficits and helps the economy grow faster in the long run.
Note: A balanced budget multiplier does not mean that it occurs when the government implements a balanced budget, where government revenue equals expenditure. However, the word “balanced” refers to changes in expenditure that are equivalent to changes in taxes. So, when doing so, the government may run a budget deficit or a budget surplus
How the balanced budget multiplier works
The budget multiplier is a combination of the effects of the expenditure multiplier and tax multiplier. It measures changes in aggregate output as a result of changes in government spending and taxes at an equivalent rate.
Because changes in spending are adjusted to changes in taxes at an equivalent rate, the government keeps the budget deficit or surplus unchanged. For example, the government increases spending by $200, from $600 to $800. At the same time, the government also raises taxes by $200, from $700 to $900. So, the budget surplus is unchanged, at $100.
Why changes in spending are more significant
When the government increases spending, it will increase aggregate output (measured by GDP). When spending rises, aggregate demand increases, stimulating increased production in the economy. The opposite effect applies when the government decreases spending.
In contrast, increasing taxes reduces aggregate demand in the economy. That leads to lower aggregate output. Conversely, when taxes go down, it will stimulate aggregate output.
Thus, changes in government spending (∆G) positively correlate with aggregate output. Meanwhile, tax changes have a negative correlation.
Here’s the key difference:
- Direct impact: When the government spends more, it directly injects money into the economy. This creates immediate demand for goods and services, stimulating businesses to produce more. The increased production translates to higher GDP.
- Indirect impact: Tax increases, on the other hand, have a more indirect effect on aggregate demand. While they reduce disposable income for households and businesses, the impact is lessened by the concept of Marginal Propensity to Consume (MPC).
Even though both spending and taxes affect aggregate demand, the direct injection of money through government spending has a more significant initial impact. While tax increases reduce disposable income, the MPC concept suggests a less-than-proportional decrease in consumption, ultimately leading to a smaller negative effect on aggregate demand compared to the positive effect of increased spending.
The net effect: more significant expenditure than tax
When the government plans ∆T = ∆G, the initial budget position does not change (remained deficit or surplus). Say, the government increases spending and taxes at an equal rate. After implementation, the expansion effect of an increase in government spending is stronger than the contraction effect of an increase in taxes. Why?
To answer that, let us recall the concept of the marginal propensity to consume (MPC), which refers to the portion of the additional disposable income allocated to the consumption of goods and services. The opposite is the marginal tendency to save (MPS), the part of extra disposable income saved. Because households spend their money on consumption and savings, MPC + MPS = 1, both MPS and MPC are less than one.
- MPC = ∆ Consumption / ∆ Disposable income = ∆ Consumption / ∆ (Revenue – Tax)
Say, the government increases the autonomous tax by $100; it will reduce private-sector disposable income by $100. The decrease in disposable income does not necessarily reduce the consumption of goods and services by $100 because to MPC is less than one.
Assuming that the MPC is 0.8, an increase in tax will result in a decrease in the expenditure of $80. The remaining $20 is saved.
- ∆ Consumption = MPC x ∆ Revenue disposable = 0.8 x 100 = 80
From this illustration, we know that tax increases reduce consumption (and ultimately aggregate demand) to a lesser extent.
Next, remember for aggregate demand formula:
- Aggregate demand = Consumption + Investment + Government expenditure + Net exports
Hence, when the government increases spending, it directly leads to an equivalent change in aggregate demand. For example, if the budget is $100, the government increases the demand for goods and services in the economy by $100.
The net effect is an increase in aggregate demand by $20 (Rp100 – $80). Over time (through the multiplier effect), the rise in output that is induced will result in a further increase in tax revenue and affect the budget position.
Limitations of the balanced budget multiplier
Critics say it does not take into account the effects of imports. The multiplier effect works through the circular flow:
- Consumption -> Production -> Income -> Consumption …..
Economists point production to domestic production, which allows the model to work. An increase in consumption stimulates production, which in turn increases income. Higher-income spurs consumption and stimulates production, which then raises income further.
In contrast, if the supply comes from imports, the model does not work. Imports reduce the multiplier effect as they represent foreign production.
In a simple model of a closed economy (with no exports and imports), a balanced budget multiplier is precisely equal to one. If the government increases its purchases and total taxes (both autonomous and induced) equally at $1, the equilibrium GDP level will increase by precisely $1.
