The ‘Free Market Multiplier Effect’

One of the basic concepts taught in first-year university economics classes around the world is the intuitively powerful though regularly abused ‘multiplier effect’. The multiplier effect is predicated on the idea that, for an increase in income, some is saved (based on agents’ marginal propensity to save) and some is spent (based on agents’ marginal propensity to consume) and this leads to extra income on top of the initial ‘injection’.

 

By the formula 1/1-MPC, if the marginal propensity to consume is 0.8 (for example), then the multiplier is 1/1-0.8 = 1/0.2 = 5 and, therefore, for every $1 increase in income, another $5 is ultimately achieved in overall economic impact.

 

It is then argued that both government spending and tax cuts will lead to increases in income that are generally more than proportional to the initial expenditure (depending on how high the marginal propensity to consume is). Indeed, there have been famous attempts to theoretically debunk the multiplier effect but this has largely fallen on deaf, politically-expedient ears.

 

What if, instead, we sought to turn the theoretical weapon of the multiplier effect back onto the interventionists and show how tax cuts can actually induce greater multipliers than government interventions? Take the very simple example of government spending on infrastructure projects vs tax cuts for those on low-incomes.

 

Government Spending on Infrastructure Projects

 

When a Government spends on an infrastructure project, it usually contracts entities to carry out this work. As a result, although there are many workers in their employ who will benefit from an increase in income, there are also many managers, directors, shareholders etc. who will also gain supernormal profits. Although there is nothing morally objectionable to profit in and of itself, these particular profits are at the taxpayers’ expense. It is likely that those individuals who profit have lower marginal propensities to consume than the workers, for example. Then there’s also the portion of the income that is necessarily spent on raw materials and other such resources – it’s self-evident that inanimate objects certainly do not have a marginal propensity to consume!

 

A Tax Cut for Low-Income Individuals and Households

 

Suppose instead that the money that would have been spent on the project was instead used as a tax cut for those on low-incomes, the multiplier effect would undoubtedly be higher. This is because individuals with lower incomes tend to have higher marginal propensities to consume than individuals with higher incomes – after all, if an individual on an annual net income of $30,000 gained $1000 from a tax cut, they are likely to spend more of that additional income (i.e they have a higher marginal propensity to consume) than a high-income individual with an annual net income of $150,000 who gains an additional $1000 as a result of interventionist, deficit-financed, government spending.

 

Concluding Remarks

 

Globally, most government spending is deficit-financed and the benefits are regularly inflated through the theoretical apparatus of the multiplier effect. However, this simple example shows how deficit-financed tax cuts are superior to deficit-financed spending (although deficit-financed anything has its drawbacks in terms of the increases in expected future tax required to finance it). Remember, therefore, that the rationale of the multiplier effect wielded gratuitously by interventionists can be inverted for the benefit of society.