Question

Compare and contrast the use of government spending changes versus tax changes as a means of influencing the course of the economy. Is one or the other preferable in specific situations? Imagine for a moment that you have two roommates, who each have opposing viewpoints on nearly everything, including politics and economics. Taylor is adamant that the best way to manage the economy is through tax changes, while Morgan insists that it’s better to adjust the economy through government spending. What would a Neoclassical economist say? What would a Keynesian economist say?

Answer 1

Argument for tax changes (neo classical)

Neoclassicals generally believe in low tax and limited government expenditure for economic growth and price stability. According to them, tax cut would increase disposable income and thus aggregate demand through personal income tax cut and also in corporate tax cut. If tax is cut on business profits, after tax productivity of the capital stock rises according to neoclassicals. Businesses can create more capitals until the marginal product of capital falls back to the long run equilibrium value through depreciation and discount rates. Increment in capital raises total output following assumption of full employment.

Neoclassicals advocate for limited government spending such as only on defense. However, they advocate to reduce spending o social security, medicare or other types of welfare spending. This theory indicates less intervention of government and advocates for self-correcting economy.

Argument for use of government spending (Keynesian economist)

Total spending = Total revenues

ð G + transfer = Taxes + debt insurance + seigniorage

Equilibrium:

C = C0 + cYd = C0 + c(Y – T + Tr) = (C0 +cTr) + cY -cT

= >Y = C+I+G

= >Y = C0 +cTr + cY -cT + I0 + G0

= > Y(1- c)= C0 +cTr -cT + I0 + G0

= > Y = (C0 +cTr -cT + I0 + G0)/ (1-c)

Therefore, dY/dG = 1/ (1-c)

Again Y = C0 + c( Y – T) + I0 + G0

= > (1- c)Y = C0 -cT+ I0 + G0

= > Y = {(C0 + I0 + G0 )-cT}/{1- c}

= > dY/ dT = -c/(1-c)

According to Keynesian theory, government expenditure multiplier has greater effect on change in GDP than tax multiplier. Income rises due to any rise of autonomous spending / multiplier. If there is an injection of extra spending, i.e, new building and equipment are bought in a firm and this boost sales revenue of those making such items. This 'first round effect' is the initial increase in income brought about through the increased spending within the economy. Employees of the equipment producer firm spend some part of the income on goods and services and save the rest. If one employee receives Rs 100 and spends Rs. 80, the MPC would be 0.8 and MPS = 0.2.

During an economic recession, tax revenues shrink because income level falls at that period and taxpayers move down the progressive tax schedule. These two factors effectively provide an automatic tax cut that puts some of the lost income back to the pockets of households, lessening the fall in their disposable income. Because the tax cut multiplier is always smaller than the spending multiplier, tax cuts are regarded as less potent in boosting the economy during a recession than are spending increases.

Unlike neoclassicals, Keynesians belief that stimulus is required for fiscal stabilization. Self-correcting process does not work well always especially during recession.