The Sophistry of the Balanced Budget Multiplier
By Bryan Caplan
If you go to an old-fashioned Keynesian macro text, it will explain that raising taxes and spending by equal amounts increases total spending. How is this possible? Well, if the Marginal Propensity to Consume=a, then the gross positive effect on nominal GDP of spending G equals:
The gross negative effect of raising taxes, however, equals:
If you subtract the first expression from the second, you find that increasing spending and taxes by G raises nominal GDP by G. Hence the famous result: The Balanced Budget Multiplier equals 1. This reasoning implies, in turn, that dollar-for-dollar, spending has a bigger stimulative effect than a tax cut of equal size.
Unfortunately, this argument is sleight of hand. How so? It assumes that government agencies automatically spend 100% of any new funds allocated to them. And strange as it seems, that assumption is often false. It takes time and effort to figure out how to spend new money, you often need the approval of multiple levels of supervision to get started, etc. The standard Keynesian analysis essentially compares a conditional effect of government spending to an unconditional effect of tax cuts. Even within the confines of the textbook Keynesian model, this is a clear case of stacking the deck in favor of spending.