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Fiscal multiplier
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Fiscal multiplier
In economics, the fiscal multiplier (not to be confused with the money multiplier) is the ratio of change in national income or revenue arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending (including private investment spending, consumer spending, government spending, or spending by foreigners on the country's exports). When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.
The existence of a multiplier effect was initially proposed by Keynes' student Richard Kahn in 1930 and published in 1931. The multiplier theory was developed to provide rigorous justification for public works spending. Lloyd George, the Liberal candidate in his 1929 election pledge had proposed a public works scheme to reduce unemployment. Keynes and Hubert Henderson wrote a pamphlet titled “Can Lloyd George Do It?: An Examination of the Liberal Pledge” backing his proposal. Richard Kahn's calculations were meant to show that much of the Treasury’s expenditure would be recouped through higher taxes and less spending on unemployment insurance.
Some other schools of economic thought reject or downplay the importance of multiplier effects, particularly in terms of the long run. The multiplier effect has been used as an argument for the efficacy of government spending or taxation relief to stimulate aggregate demand.
In certain cases multiplier values less than one have been empirically measured (an example is sports stadiums), suggesting that certain types of government spending crowd out private investment or consumer spending that would have otherwise taken place. This crowding out can occur because the initial increase in spending may cause an increase in interest rates or in the price level. In 2009, The Economist magazine noted "economists are in fact deeply divided about how well, or indeed whether, such stimulus works", partly because of a lack of empirical data from non-military based stimulus. New evidence came from the American Recovery and Reinvestment Act of 2009, whose benefits were projected based on fiscal multipliers and which was in fact followed—from 2010 to 2012—by a slowing of job loss and job growth in the private sector.
The other important aspect of the multiplier is that to the extent that government spending generates new consumption, it also generates "new" tax revenues. For example, when money is spent in a shop, purchases taxes such as VAT are paid on the expenditure, and the shopkeeper earns a higher income, and thus pays more income taxes. Therefore, although the government spends $1, it is likely that it receives back some proportion of the $1 in due course, making the net expenditure less than $1.
Where the government spending is in the form of wages and salaries, there will be an almost immediate recouping of an amount of income tax and other forms of income taxation (such as National Insurance in the UK). This is also true to some extent with spending on pensions and benefits.
For example, suppose that a government spends $1 million to have a factory built. The money does not disappear, but rather becomes wages to builders, revenue to suppliers etc. The builders will have higher disposable income, and consumption may rise, so that aggregate demand will also rise. Supposing further that recipients of the new spending by the government in turn spend their new income, this will raise demand and possibly consumption further, and so on.
The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives $1 million and pays out $800,000 to sub-contractors, he has a net income of $200,000 and a corresponding increase in disposable income (the amount remaining after taxes).
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Fiscal multiplier
In economics, the fiscal multiplier (not to be confused with the money multiplier) is the ratio of change in national income or revenue arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending (including private investment spending, consumer spending, government spending, or spending by foreigners on the country's exports). When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.
The existence of a multiplier effect was initially proposed by Keynes' student Richard Kahn in 1930 and published in 1931. The multiplier theory was developed to provide rigorous justification for public works spending. Lloyd George, the Liberal candidate in his 1929 election pledge had proposed a public works scheme to reduce unemployment. Keynes and Hubert Henderson wrote a pamphlet titled “Can Lloyd George Do It?: An Examination of the Liberal Pledge” backing his proposal. Richard Kahn's calculations were meant to show that much of the Treasury’s expenditure would be recouped through higher taxes and less spending on unemployment insurance.
Some other schools of economic thought reject or downplay the importance of multiplier effects, particularly in terms of the long run. The multiplier effect has been used as an argument for the efficacy of government spending or taxation relief to stimulate aggregate demand.
In certain cases multiplier values less than one have been empirically measured (an example is sports stadiums), suggesting that certain types of government spending crowd out private investment or consumer spending that would have otherwise taken place. This crowding out can occur because the initial increase in spending may cause an increase in interest rates or in the price level. In 2009, The Economist magazine noted "economists are in fact deeply divided about how well, or indeed whether, such stimulus works", partly because of a lack of empirical data from non-military based stimulus. New evidence came from the American Recovery and Reinvestment Act of 2009, whose benefits were projected based on fiscal multipliers and which was in fact followed—from 2010 to 2012—by a slowing of job loss and job growth in the private sector.
The other important aspect of the multiplier is that to the extent that government spending generates new consumption, it also generates "new" tax revenues. For example, when money is spent in a shop, purchases taxes such as VAT are paid on the expenditure, and the shopkeeper earns a higher income, and thus pays more income taxes. Therefore, although the government spends $1, it is likely that it receives back some proportion of the $1 in due course, making the net expenditure less than $1.
Where the government spending is in the form of wages and salaries, there will be an almost immediate recouping of an amount of income tax and other forms of income taxation (such as National Insurance in the UK). This is also true to some extent with spending on pensions and benefits.
For example, suppose that a government spends $1 million to have a factory built. The money does not disappear, but rather becomes wages to builders, revenue to suppliers etc. The builders will have higher disposable income, and consumption may rise, so that aggregate demand will also rise. Supposing further that recipients of the new spending by the government in turn spend their new income, this will raise demand and possibly consumption further, and so on.
The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives $1 million and pays out $800,000 to sub-contractors, he has a net income of $200,000 and a corresponding increase in disposable income (the amount remaining after taxes).