A tax-cutting fiscal stimulus
It is now possible to explore the impact of cutting the tax rate from t0 to t1. Since a higher proportion of income is now available for consumption (a reduced leakage of taxes in the circular flow of income), this provides a boost to aggregate demand. This tax reduction will be modelled in order to illustrate a key fiscal policy arm available to policymakers: the manipulation of taxation in order to stimulate aggregate demand.
In response to a tax cut, the initial reduction in tax payments ΔT is equal to
ΔT = (t0 − t1)Y0
where Y0 is the level of income before the tax change. The change to tax receipts depends on the difference (t0 − t1) between tax rates before and after the change.
Now let the initial level of income (Y0) be £600 million, and let the initial tax rate (t0) be 0.1. Suppose that the tax rate falls to t1 = 0.05 (only 5% rather than 10% of national income is taken in tax). Hence the initial reduction in tax receipts is
ΔT = (0.1 − 0.05) × 600 = 0.05 × 600 = £30 million
The reduction in the tax rate to 5% generates a £30 million cut in total tax receipts. This means a £30 million increase in disposable income.
The ‘windfall’ increase in disposable income will lead to an increase in consumption spending, but this increase will be less than the full £30 million. Assuming that the marginal propensity to consume is 0.8, and remains at this value, households will spend only 80% of their additional income. Instead of stimulating aggregate demand, 20% of the tax windfall leaks into savings accounts in banks and building societies. Hence the stimulus to aggregate demand is
b ΔT = 0.8 × £30 million = £24 million
Households will choose to save £6 million of the £30 million tax windfall, and spend £24 million on additional consumption. So aggregate demand is boosted by £24 million.
In addition, the fall in the tax rate increases the value of the multiplier:
The reduction in the tax rate increases the multiplier from 3.57 to 4.17. The combined effect of these two changes is an increase in income of
4.17 × £24 million = £100 million
For a multiplier of 3.57 (as in the above example, with initial tax rate 10% and a marginal propensity to consume of 0.8), calculate the multiplier impact on income of an increase in government spending ΔG = £30 million.
This activity allows you to compare the above tax cutting example with a fiscal stimulus based on increased government spending. With a multiplier of 3.57, the final increase in income from the increase in government spending is 3.57 × £30m = £107.1 million. Even without the benefit of an increase in the multiplier, an increase in government spending delivers a higher boost to income than an equivalent tax cut: £7 million more in this example.
The key difference between these two types of fiscal policy is the leakage of part of the tax cut into saving. In the current example, the government spends the full £30 million, whereas households spend only £24 million of the £30 million windfall and save the rest. The exact outcome of the comparison does, of course, depend on the values of b and (t0 − t1). The effect of a tax cut will be enhanced if there is a very high marginal propensity to consume, so that most of the windfall is spent, and also if there is a substantial increase in the value of the multiplier owing to a large fall in the percentage tax rate.
Keynes was not very keen on stimulating aggregate demand through tax cuts. As shown by Brown-Collier and Collier (1995), he cautioned that tax cuts do not provide any future benefits to the economy; he also thought that it would be difficult to persuade the public that tax cuts should be reversed once they became established. Further issues relating to these two types of fiscal policy are considered in the analysis that follows.