Tax multipliers

A commenter on my last post suggested that Greg Mankiw would have a problem with my statement that spending multipliers exceed tax multipliers. That surprised me because as was written in this textbook (p.397):

The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. When the government cuts taxes and stimulates consumer spending, earnings and profits rise, which further stimulates consumer spending. This is the multiplier effect. (The multiplier effect for a tax change will be less than the multiplier effect of an equivalent change in government spending.)

It then goes on to contrast the multiplier effect with the crowding out effect that comes from potentially higher costs of borrowing from government borrowing (whether taxing or spending driven). You need to consider these effects together to work out the total stimulus. Greg refers to all this here.

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Greg does think that the type of tax cuts matter.

Suppose, for example, that tax cuts are not lump-sum but instead take the form of cuts in payroll taxes (as suggested by Bils and Klenow). This tax cut would reduce the cost of labor and, if labor and capital are complements, increase the demand for capital goods. Thus, the tax cut stimulates demand not only by increasing disposable income and consumption spending (the textbook Keynesian channel) but also by incentivizing more investment spending. A similar result might obtain if the tax cut included, say, an investment tax credit.

However, I do not believe he is suggesting that tax revenue would rise.

But this is what Julie Bishop is saying. Let t be the rate of taxation, T be tax revenue and Y be output. Bishop is saying this:


This path involves two assumptions. First, that we are on the wrong side of the Laffer curve. I don’t believe this and even if we must have been there prior to 2007 so what was the Coalition doing? Second, that the increase in tax revenue will increase output. This is contrary to macroeconomic theory.

What is the evidence of the impact of tax revenue increases on output? Christina and David Romer look at this in their paper. One thing they point out is that, in the US since the 1970s, taxes do not appear to have been used for discretionary fiscal policy and changes in tax rates tend to be for long-run policy reasons. And when they identify tax changes not motivated by long-run effects, these appear to have a smaller effect on output.

In my reading of the paper, they examine the taxation revenue share of GDP and changes in it on GDP itself. They find that a 1% increase in tax revenue share has a negative impact on GDP of between 1.3% and 3%. The higher multipliers appear to come through a path whereby increased tax revenues results in low business investment.

So let me put it very clearly. Even if Bishop is right and tax rate cuts increase tax revenue, then this is going to drag the economy further into recession. How much it does so depends upon how much of an increase in tax revenue there is (you could over the top of the Laffer curve) and upon the strength of the tax multiplier. Bishop things that the latter one is large. Whadda you say what?

Here is the thing. There is so much the Opposition could legitimately be arguing now to put forward a case that more of the stimulus should be in the form of tax cuts rather than spending increases. The obvious is that the spending might be misdirected and it is a good long-term thing to get taxes down so we should take the opportunity rather than trying to fine tune the economy.

They could also argue that tax cuts should be structured in a way that stimulates. Of course, given that business investment is not being hit, the obvious place for those cuts is towards the lower end of the income spectrum. But that wouldn’t be hitting Bishop’s political base, would it?


5 thoughts on “Tax multipliers”

  1. A bit of selective quoting from Mankiw. He also says

    <blockquote> The puzzle is that, taken together, these findings are inconsistent with the conventional Keynesian model. According to that model, taught even in my favorite textbook, spending multipliers necessarily exceed tax multipliers.</blockquote>

    Then later in the post, he says
    <blockquote>The results of all these authors suggest you need to go beyond the standard Keynesian model to understand the short-run effects of fiscal policy.

    My advice to Team Obama: Do not be intellectually bound by the textbook Keynesian model. Be prepared to recognize that the world is vastly more complicated than the one we describe in ec 10. In particular, empirical studies that do not impose the restrictions of Keynesian theory suggest that you might get more bang for the buck with tax cuts than spending hikes.</blockquote>

    In another post on the same topic (January 10), he writes, ‘Team Obama assumes that tax changes are less than half as potent in influencing the economy as the new CEA Chair estimated them to be in her own research.’

    So I’m going to take Mankiw at his word, ‘Be prepared to recognize that the world is vastly more complicated than the one we describe in ec 10’ and go with the  empirical evidence of large tax effects and small government spending effects.


  2. Sinclair is right. Mankiw’s point is that the standard IS/LM framework suggests that the public spending multiplier should be larger than the tax multiplier, but then refers to the more recent empirical literature that suggests that this might not be so.


  3. You just have to have read his blog over the past few months to understand that while he thinks a stimulus is necessary, that it is not at all clear that it should be weighted toward public spending rather than tax cuts.


  4. Joshua,

    Your logic is usually pretty good but I agree with Sinclair, I think you’ve completely misquoted Odumbo’s reference to Mankiw.  And unlike your usual arguments you’ve taken a selective and quite “political” attack by (deliberately??) misconstruing his reference as arguing something it didn’t.

    While Odumbo does argue Julie Bishop’s point on tax cuts increasing tax revenue, his reference to Mankiw is on the “evidence” and not the theory of the multiplier effect of tax cuts.  Your post confuses the two issues – implying Odumbo was using Mankiw to support the  Bishops arguments on tax revenue and not the multiplier effect.

    To make it worse I think your post misleads people on what Mankiw’s argument is about.  That is that while keynesian theory says one thing – there is evidence that points to a greater multiplier effect from tax cuts than spending increases.  Probably from the real world not running with some of the assumptions of Keynesian theory. Something not really addressed by your argument.

    Perhaps you’d be better rewarded by addressing the argments as they are put forward rather than as you’d like them to be.

    I look forward to a less … confused … post from you on the issue.


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