Recessionary Gap and Fiscal Policy

Readers Question: How could equal-size increases in G and T eliminate a recessionary gap?

In theory, an increase in government spending of £2bn would be an injection into the economy and cause an increase in GDP of £2bn. However, if the government increased taxes by £2bn, the effect would be neutralised. In short higher government spending increases aggregate demand, but, higher taxes reduce it.

Yet, it is possible for equal size increases in G and T to eliminate a recessionary gap.

The government spending should be targeted to building infrastructure projects which employ unemployed people. This spending will have a direct effect in increasing incomes. Many related industries will benefit creating a multiplier effect in the economy. If the unemployed are given jobs to build roads, they get increased income but also will spend more benefiting local shops and bars. Therefore, the initial government injection of £2bn may lead to a final increase in GDP of say £3bn.

If the government increased taxes on wealth or high income earners there may be little negative impact on consumer spending and economic growth. For example, if the government increased inheritance tax by £2bn, there would be little negative impact on consumer spending. People don’t usually spend all their inheritance straight away, but save it in banks.

It is possible the government could increase aggregate demand by increasing taxes on high income earners and cutting taxes for low income earners. This is because low income earners have a much higher marginal propensity to consume. If you place tax on high income earners they will reduce their spending, but, the effect will be less than if you had increased taxes on low income earners.