TAX CUTS AND HOW MYOPIA CHAINS OUR PERCEPTIONS

What form should government expenditure take? Is the fiscal stimulus best ensured by increasing government expenditure or reducing taxes?

- BIBEK DEBROY

EVERY undergraduate student of economics will be exposed to the concept of a multiplier. Indeed, the use of the term has become part of standard jargon. A multiplier measures the factor by which one variable changes with respect to another. That sounds vague. There are multipliers and multipliers. Hence, let’s impart some precision to that vague statement by applying it to a specific type of multiplier: The fiscal multiplier. National income results from consumption, private investments, government expenditure, or exports. An increase in expenditure on any of these four leads to an increase in national income. By how much is the question. If the increase in national income is more than the initial increase in expenditure, there is a multiplier or magnifying effect. That is, the multiplier is more than one. It is by no means axiomatic that the multiplier will be more than one. It can conceivably be less. When the multiplier is more than one, there is a chain reaction at work. The government builds national highways. Contractors are hired. There is employment. Wages/ salaries are spent. There is greater consumption, stimulating demand. When these are aggregated, the total increase in national income is greater than the initial spending by the government. This is an example of a fiscal multiplier, relating to government expenditure.