Why Government Spending Over Tax Cuts?

In my last blog I indicated that increasing government spending has a larger impact on the economy that tax cuts. A reader has asked me to explain this as a Part 2 to that blog and I will take this opportunity to do so.

The problem arises from something called the multiplier. Whenever income is spent it becomes income to someone else. People do not spend all of their income. Some is saved, some is used to pay down debt, and some is spent overseas (imports). The multiplier is 1 divided by the proportion of new income not going to spending. To get the total re-spending effect we multiply the initial spending by the multiplier. If on average people do not spend 10% of their new income then the multiplier would be 1/.10 = 10. Therefore, a tax refund of $100 million would result in initial new spending of $90 million and a total re-spending effect of $90 x 10 = $900 million.

On the other hand, if the government builds new roads equal to $100 million the initial new spending is the $100 million. The total re-pending effect would then be $100 million x 10 = $1 trillion. A little algebra indicates that getting a $1 trillion increase in economic activity would require $111 million in tax cuts. In this simple example tax cuts would cost the treasury 11% more than increases in public spending. Lets face it, this means 11% higher cost to us. Either way the government would be required to borrow. The issue is which leads to a lower debt?

The right wing says so what if tax cuts cost more; we know how to spend our money better than the government does. The question is: do we? Will we spend our tax cuts rebuilding our infrastructure? Will we install sewage treatment plants? Will we invest in clean coal research? All of these things need doing but the private sector returns for doing them are limited.