Balanced Budget Fiscal Expansion is an attempt to increase aggregate demand through changing spending and taxation levels, whilst leaving the overall fiscal budget situation the same.
Essentially, the idea is that if you increase spending and taxes equally, the increased government spending has a bigger positive impact on economic growth than the negative impact of higher taxes.
A key factor in balanced budget fiscal expansion is the idea of the multiplier effect. Through the multiplier effect, higher government spending on capital projects may cause a bigger final increase in real GDP. (e.g. with a multiplier effect of 1.5 – £1bn of government spending, may increase real GDP by £1.5bn) Therefore, by financing capital investment through higher taxes we can, in theory, increase economic growth without increasing the budget deficit.
To explain the idea of balanced budget fiscal expansion it is best to use examples. Two ideas spring to mind.
1. Reduce spending on pensions, increase spending on capital investment.
If the government increased the retirement age it would reduce government spending on pensions. The money saved can be used to finance higher capital investment. Overall government spending remains unchanged, but people are working longer, and the government can finance capital investment which can increase aggregate demand.
2. Increase Income Tax for a temporary period and use the money to finance capital investment.
The social market foundation recently proposed bringing forward £15bn of tax increases and using this to spend on infrastructure spending. (PDF)
If income tax were increased for a short period, say three years, people would tend to spend less, therefore there would be a fall in consumer spending. However, the government could use the money raised to finance capital investment. For example, building schools, building roads or a new airport in London. Therefore government spending will increase and offset the fall in consumer spending.
If there is no multiplier effect, the fall in consumer spending will be equally offset by a rise in government spending. Economic growth and the budget will be unchanged.
However, if the multiplier effect of government investment is greater than one, then there can be an increase in economic growth.
For example, if the government increased spending on roads and railways, there would be a direct increase in demand from the government spending, but there could also be knock on effects to the rest of the economy. Construction firms would take on unemployed workers; these former unemployed workers would now spend more – causing a further round of increased spending in the economy.
Furthermore, they may also be a supply side impact from the investment. Business say the lack of another airport in London is holding back investment in the South East. If capital spending increases transport links, it can benefit the supply side of the economy in the long term, which is an additional benefit to long term economic growth.
Also high profile capital expenditure projects may help to boost consumer and business confidence. Therefore, this could increase spending and Aggregate Demand even more.