Balanced Budget Fiscal Expansion

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.

Will the Multiplier effect be Greater Than One?

A key question is whether the multiplier effect will be greater than one. Given that the economy is in recession, and there is spare capacity, spending on capital investment could help kick-start the construction sector and reduce unemployment. If unemployment falls, you would expect to see a positive multiplier effect from capital investment.

If the economy was already at full capacity, an increase in tax and government spending, would have a lower multiplier effect because there is less spare capacity and unemployment in the economy. If the economy was close to full capacity, there would be a strong argument than higher government spending would merely cause crowding out.

Impact on Real Interest Rates

If an economy has very low inflation expectations and zero (0.5%) interest rates, this policy of higher government spending may change real interest rates. The higher capital investment may increase inflation. But, if interest rates remain the same, real interest rates will fall, encouraging borrowing, investment and spending.

Evaluation of Balanced Budget Fiscal Expansion

  • Increasing taxes could create disincentives to work. Some economists argue that we actually need to cut income tax to boost incentives to work and invest.
  • Some economists would be concerned about increasing the size of the state (which higher taxes and spending would do). They argue that temporary increases in taxes and spending are, in practise, hard to reverse when the economy has recovered.
  • Government spending may be used inefficiently, and therefore it doesn’t improve the supply side of the economy.
  • Other economists argue that since  we are in a liquidity trap and bond yields have fallen rapidly, it is a mistake to worry about balancing the budget in the short-term. We should just increase capital spending, financed through either borrowing or printing money. There is no need to worry about balancing the budget.
  • If the capital investment does create a multiplier effect and higher growth, then the budget situation should improve – not stay the same. Improving economic growth is crucial for improving tax revenues and reducing debt to GDP ratios.
  • If austerity is self-defeating, expansionary fiscal policy financed by borrowing could actually help improve the cyclical deficit over time.
  • If consumers really believe the tax increases are temporary, then the impact on current consumption may be small. Consumers may attempt to smooth consumption over their life cycle and so continue to spend because they expect taxes to be cut in future years.

Further Reading

Related

  • Fiscal devaluation – cutting tax on labour to improve competitiveness without devaluation of exchange rate
By on September 5th, 2012

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