The immediate expansionary impact of a tax cut, designed to generate $x revenue at the current level of national income, will be less than an increase of public spending cut of $x.
Answer: True
The answer is True.
The question is only seeking an understanding of the initial injection of the spending stream rather than the fully exhausted multiplied contraction of national income that will result. It is clear that the tax rate decrease will have two effects: (a) some initial spending stimulus as people have more disposable income; and (b) it increases the value of the expenditure multiplier, other things equal.
We are only interested in the first effect rather than the total effect. But I will give you some insight also into what the two components of the tax result might imply overall when compared to the impact on demand motivated by an increase in government spending.
To give you a concrete example which will consolidate the understanding of what happens, imagine that the marginal propensity to consume out of disposable income is 0.8 and there is only one tax rate set at 0.20. So for every extra dollar that the economy produces the government taxes 20 cents leaving 80 cents in disposable income. In turn, households then consume 0.8 of this 80 cents which means an injection of 64 cents goes into aggregate demand which them multiplies as the initial spending creates income which, in turn, generates more spending and so on.
Government spending increase
A rise in government spending (say of $1000) is what we call an exogenous injection to the aggregate spending stream and this directly increases aggregate spending (demand) by that amount. So it might manifest as a new order for $1000 worth of gadget X from some private supplier.
The firm that produces gadget X thus will increase the production of the good or service by the amount of the new orders ($1000) and as a result incomes of the productive factors working for and/or used by the firm also increase by $1000. So the initial rise in aggregate demand is $1000. Remember that spending equals income.
This initial rise in national output and income would then induce a further rise in consumption by 64 cents in the dollar so in Period 2, aggregate demand would rise by a further $640. Output and income then rise further by the same amount to meet this increase in spending and sales (spread throughout the economy).
In Period 3, aggregate demand rises by 0.8 x 0.8 x $640 and so on. The induced spending increase gets smaller and smaller because some of each round of income rise is taxed away, some goes to a rise in imports and some manifests as a rise in saving.
Tax-decrease induced expansion
The expansion coming from a tax-cut does not directly impact on the spending stream in the same way as the rise in government spending.
First, the question assumes that the government introduces a tax rate cut that increases its initial fiscal deficit by the same amount as would have been the case if it had increased government spending (so in our example, $1000).
In other words, overall disposable income at each level of GDP rises initially by $1000. What happens next?
Some of the rise in disposable income manifests as increased saving (20 cents in each dollar). So the stimulus to consumption spending is equal to the marginal propensity to consume out of disposable income (0.8) times the rise in disposable income (which if the MPC is less than 1 will be lower than the $1000).
In this case the rise in aggregate demand is $800 rather than $1000 in the case of the increase in government spending.
What happens next depends on the parameters of the macroeconomic system. The multiplied rise in national income may be higher or lower depending on these parameters. But it will never be the case that an initial fiscal equivalent tax cut will provide more stimulus to national income than a rise in government spending.
Note in answering this question I am disregarding all the nonsensical notions of Ricardian equivalence that abound among the mainstream economists. I am also ignoring the empirically-questionable mainstream claims that tax decreases stimulate work incentives which force each worker to supply more labour. You can avoid this issue by imagining that the tax cut is in the form of a change to a value-added tax.
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