Fiscal policy Group: mm-72

To achieve a particular increase in AD, taxes would have to be CUT by more than spending would have to INCREASE. There is a reason for this:

• A tax cut is an INDIRECT injection into the nation’s economy.
• A tax cut increases the disposable incomes of households
• Higher disposable incomes leads to more consumption, but also increases savings and imports, both leakages.
• The actual increase in spending, therefore, is less than if the government were to increase AD directly through new government spending.
• Fiscal stimulus (both tax cuts and spending increases) lead to a budget deficit
• Assuming a government started with a balanced budget, if it wanted to stimulate AD, the government would have to incur a deficit.
• A tax cut will require the government incurs a LARGER deficit in order to stimulate AD by a certain amount than a spending increase.

Expansionary Fiscal Policy

Expansionary Fiscal Policy – Understanding the effect

Once an expansionary fiscal policy has been undertaken, it impact on the economy can be understood as follows:

• After an increase in government expenditures: Government may spend more on current expenditures or capital expenditures.
• The effect is that households see more employment opportunities as the government demands more goods and services.
• There is an immediate increase in AD by the amount of increased government spending, but then household consumption and investment by firms increase as well, since there is greater income and more demand in the economy
• The ultimate increase in AD is thereby multiplied by a factor determined by the proportion of the initial change in incomes that led to further consumption (the MPC)
• After a tax cut: Governments may reduce the level of taxes, or offer tax refunds, to households and businesses.
• The private sector sees its disposable income increase, leading to more consumption and investment, but…
• Some of the tax cut will be ‘leaked’ as increases savings and investment.
• The increase in AD will be multiplied by a factor determined by the MPC. But the tax multiplier will always be less than the spending multiplier due to the leakage that results from a tax cut.

Expansionary Fiscal Policy

Expansionary Fiscal Policy – Illustrating the effect

The impact of a tax cut or increase in government spending can be illustrated as follows

PL