This is my first diary. I am trying to show how the simple, generally accepted tools of macroeconomic theory can be used to explain why current Republican deficit reduction policy makes little sense. The presentation below suggests that, under a realistic set of simplifying assumptions, tax increases will have a less adverse impact on U.S. output and employment than reductions in government spending. From the standpoint of doing the least possible damage to the economy in the short run, tax increases, especially on upper income workers, are to be preferred over reductions in government spending, or tax increases on lower and middle income workers.
The following analysis makes use of one of the most basic analytical devices in macroeconomic theory: the basic, closed economy Keynesian Cross Framework. Like most simple economic models, this one abstracts from numerous real world complexities, particularly the effect of fiscal policy on interest rates. The conclusions that will be derived below, however, would not substantively change if interest rates were introduced into the model (under most assumptions regarding the relationship between the velocity of money and the real money supply).
Many readers will find this analysis familiar: if you’ve ever taken a class in Introductory Macroeconomic Theory, chances are you’ve encountered this theoretical framework before. My apologies in advance for sounding didactic or bringing back bad memories.
Here is the notation:
∆ = the change in the variable following the delta sign
C = Consumption Spending = b(GDP – T)
T = Net Tax Payments = Taxes minus Transfer Payments
b = the Marginal Propensity to Consume; the additional spending that takes place when income increases by $1
I = Investment Spending (assume it is determined by exogenous forces)
G = Government Purchases (assume it is determined by exogenous forces)
GDP = Real Gross Domestic Product = The U.S.’s output of goods and services per year, adjusted for changes in the level of prices.
The economy is in short run equilibrium where output = income = spending. In other words:
GDP = C+I+G
When any component of spending changes, the effect on GDP is given by:
∆GDP = 1/(1-b) x ∆ (C+I+G)
Suppose the public’s marginal propensity to consume is .9. The spending multiplier—the term 1/(1-b)—will then equal 10. Thus a $1 billion decrease in Government purchases will cause GDP to fall by $10 billion.
On the other hand, an identical tax increase will have a much smaller negative effect on GDP, for two reasons. First , only part of the tax increase would have been spent in the first place. So the initial decrease in spending that occurs before the multiplier effect kicks in will be only a fraction of the tax increase.
It is also reasonable to assume that higher income people have a lower Marginal Propensity to Consume than middle and lower income people, who tend to spend a far larger portion of each additional dollar that they earn.
If we suppose that higher income individuals have a Marginal Propensity to Consume of .5, then a $1 billion tax increase will cause total spending to initially decrease by $500 million. If we continue to assume that the general public’s Marginal Propensity to Consume is .9, then the tax increase would cause GDP to decrease by the initial change in spending (negative $500 million) times the spending multiplier, or by $5 billion.
The adverse impact of a tax increase on GDP will increase as the marginal propensity to consume of the group whose taxes go up increases. Tax increases for the wealthy are therefore to be preferred to tax increases on middle income earners, which are to be preferred over tax increases on lower income earners.
Thus, while a $10 billion decrease in Government Purchases and a $10 billion increase in taxes will have an identical impact on reducing the Federal Government Budget Deficit, the tax increase will always have the LEAST adverse effect on output and employment.
Taking the idea of tax increases “off the table” when negotiating ways to reduce the government budget deficit is not only inequitable and immoral, it also makes no sense economically, especially when economic growth is sluggish and unemployment is high.
Any reduction in the deficit will initially cause GDP to decrease, which is why NO fiscal contraction should be attempted at this time. But if you must, please rely most heavily on tax increases, particularly on upper income earners, who save a greater fraction of their income than middle and lower income earners.