Multiplier Theory with Tax Rates as Policy Instruments

Abstract

Historically, the balanced budget multiplier theorem was important because it corrected the widely held view that the size of the deficit or surplus was the magnitude which indicated the effect of the budget on the economy. The theorem is still emphasised today because this focus of attention on the size of the deficit is not completely dispelled. But in itself the balanced budget multiplier is not particularly important. Budgets rarely are balanced. In any case, the size of the deficit is not something that is normally under the control of the government. It is not an instrument of policy. In most circumstances it is legitimate to regard government expenditures as a policy instrument, but not government receipts, and hence not the deficit. With constant taxation rates, the level of receipts varies with the level of national income. If national income is lower than that expected when the budget was planned, taxation receipts will be lower than expected, and the deficit bigger.1 It is taxation rates, not taxation receipts, that are under the direct control of the government. Multipliers for government expenditure are relevant to fiscal policy; except in the case of lump sum taxes, those for taxation receipts are not. What are needed are figures giving the ratio between a change in taxation rates and the consequent change in national income.