A balanced budget multiplier measures changes in aggregate output when the government changes its spending and taxes at an equivalent rate. In a closed economy, a multiplier is equal to one, which means that the multiplier effect of a change in tax offsets everything except the initial production that is triggered by a change in government purchases.
A brief definition: a multiplier and a balanced budget
In economics, multiplier means, 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 will multiply the money supply in the economy by 20 = 1/5%. So, if the bank lends one rupiah and circulates in the economy, it will become Rp20.
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 increase investment. The shift also shrinks trade deficits and helps the economy grow faster in the long run.
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 Rp200, from Rp600 to Rp800. At the same time, the government also raises taxes by Rp200, from Rp700 to Rp900. So, the budget surplus is unchanged, at Rp100.
The effect of changes in government spending and taxes on aggregate output
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 correlates with aggregate output. Meanwhile, tax changes have a negative correlation.
The net effect: changes in expenditure will be more significant than the impact of changes in 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 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 Rp100; it will reduce private-sector disposable income by Rp100. The decrease in disposable income does not necessarily reduce the consumption of goods and services by Rp100 due to MPC is less than one.
Assume that MPC is 0.8, an increase in tax will result in a decrease in the expenditure of Rp80. The remaining Rp20 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 Rp. 100, the government increases the demand for goods and services in the economy by Rp100.
The net effect is an increase in aggregate demand by Rp20 (Rp100 – Rp80). 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.
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 the consumption and stimulates production, and then raises income further.
In contrast, if the supply comes from imports, the model does not work. Imports reduce the multiplier effect as it represents foreign production.
In a simple model of a closed economy (with no export and import), a balanced budget multiplier is precisely the equal as one. If the government increases its purchases and also increases total taxes (both autonomous and induced) equally at Rp1, the equilibrium GDP level will increase by precisely Rp1.