The GDP Multiplier Effect

Which takes a bigger bite out of the economy, government spending cuts or tax hikes?

The chart shows the relative size of the bite that each takes out of GDP as a percentage of each dollar in cut spending or in increased taxes:

What we see is that for every $1 in government spending cuts, the nation's GDP only shrinks by about 60 cents (at least while its unemployment rate is above 7.5%). Meanwhile, every $1 increase in taxes will reduce the nation's GDP by three times that amount below what it might otherwise be.

That's a big reason why over 90% of the fiscal drag on the U.S. economy that the International Monetary Fund is so concerned about is due to President Obama's fiscal cliff tax hikes, and why less than 10% has anything to do with government spending cuts. Not to mention why the IMF is so anxious for the Fed to sustain the pace of its current quantitative easing efforts.

Why do government spending cuts have so much less than a dollar-for-dollar impact? Perhaps the easiest explanation is that about 30-40% of all government spending is wasted in non-value added, non-productive activities that make no positive contribution to the nation's gross domestic product.

Meanwhile, when the government hikes its taxes, it's really acting to penalize the most productive people in the nation to support its wasteful spending activities. The multiplier is so large because tax hikes are so disruptive in their immediate negative effect upon the economy.

By contrast, it takes time for the GDP multipliers for tax cuts to build to the same level of magnitude. That's because it takes time for money to be redirected into more productive activities from where it was before the tax cuts went into effect. Even so, when first implemented, the multiplier for tax cuts is about the same in magnitude as the multiplier for government spending, with the difference being that with tax cuts, there's a positive feedback effect involved that makes its multiplier continue grow to its peak magnitude in about three years time before dropping back slowly, but never fully dissipating.

What's more, these particular GDP multipliers are especially significant because they keep turning up everywhere. For example, if you want to explain why Spain's GDP crashed by the exact amount it did in 2012, look no further than its spending cuts and especially its tax hikes of that year. Or if you want to explain the Greek economic crash of 2010, you can simply look at what its government did in that year to trim its spending and especially what it did to hike its taxes, then apply these multipliers to see how they affected Greece's GDP.

They also appear to hold for how the U.S. economy performed in the first quarter of 2013, where fortunately, the Fed's quantitative easing programs more than offset the negative aspects of President Obama's tax hikes along with some pretty trivial government spending cuts after they went into effect. Despite the Fed's action, the U.S. provides the third direct example of these exact multipliers almost perfectly accounting for the negative drag of poorly considered fiscal policies on a nation's economy.

The evidence, by the way, says the exact same multipliers appear to work in explaining how the United Kingdom's economy has behaved over the past several decades.

Given the differences in history, institutions, laws, and the overall structures of their economies, there's really no reason to expect that these seemingly universal GDP multipliers should be so effective in describing the impact of changes in government spending and especially of their tax policies in affecting so many different national economies. That they would seem to have such predictive power is something that perhaps ought to be studied further.

References

Owyang, Michael T., Ramey, Valerie A. and Zubairy, Sarah. Are Government Spending Multipliers Greater During Periods of Slack? Evidence from 20th Century Historical Data. [PDF Document]. Federal Reserve Bank of St. Louis. Economic Research Division. Working Paper 2013-004A. January 2013.

Romer, Christina D. and Romer, David H. [PDF document]. . The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks. [PDF Document]. March 2007.

Cloyne, James. What Are the Effects of Tax Changes in the United Kingdom? New Evidence from a Narrative Evaluation. [PDF Document]. CESIFO Working Paper No. 3433. April 2011.