Simon Wren-Lewis says the idea of a balanced budget multiplier - the notion that a rise in public spending paid for by higher taxes will increase aggregate demand - is “a pretty robust bit of macroeconomic theory.”
Not so robust, it would seem, as to convince Tories. This week Liam Fox and Tim Montgomerie have called for the exact opposite - cuts in taxes financed by cuts in government spending. From a balanced budget multiplier perspective, this combination would depress demand. This is simply because £100 of extra public spending is £100 of higher aggregate demand, whilst £100 of tax cuts are a smaller boost to aggregate demand to the extent that some of the cuts are saved. Net, then, aggregate demand falls.
So, how can Simon be wrong and Tim & Liam right? I can think of two possibilities, both of which in effect leverage up the tax cuts to give a marginal propensity to spend out of them of more than one:
- Households will see tax cuts now as a promise of more cuts to come. They might therefore borrow against higher expected future incomes.
- If tax cuts incentivize businesses to expand, they might borrow to invest, and so aggregate demand would rise by more than the amount of the tax cut.
Both these mechanisms would be doubtful at the best of times. And these are not the best of times. With banks reluctant to lend, it’s surely less likely now than ever before that tax cuts could be leveraged up in these ways. There’s not much point giving people incentives to expand their businesses if attempts to do so are met with a “no” from the bank.
From an economists point of view, then, today is the wrong time to be fighting against the balanced budget multiplier.
But are Tim and Liam thinking as economists? I suspect not. They’re thinking as politicians. They seem to want to shrink the state for reasons other than likely short-run macroeconomic effects. And I guess they’re betting that - given popular (or at least media) hostility to the public sector - tax and spending cuts would be popular.
Maybe they’re right on both counts. But please remember that macroeconomic orthodoxy and political expediency are different things.