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It’s official: spending cuts harm the economy more than tax rises

Economists use something called the fiscal multiplier to assess how changes in government spending and taxes will affect the wider economy.

The concept is quite straightforward – the multiplier shows how much a £1 change in a certain policy will change GDP (or national income). So if a particular type of government spending has a multiplier of 1.0, then increasing that spending by £1 should also increase GDP by £1. If the multiplier is 1.5, then a £1 increase in that type of spending will raise GDP by £1.50p. Conversely if the multiplier is only 0.5, than a £1 increase in that type of spending will only increase GDP by 50p.

Whilst such multiplier numbers will always be a subject to some uncertainty, they provide a good framework for thinking about how to reduce the deficit whilst minimising the hit to the wider economy.

Whether one uses the multipliers as estimated by George Osborne’s own Office of Budgetary Responsibility (page 96, pdf), those of the non-partisan US Congressional Budget Office (pdf), those of the IMF (page 35, pdf), or those estimated by credit ratings agency Moodys (page 3, pdf), two important trends are clear.

• First, cuts in government spending have a higher multiplier than increases in taxation. So spending cuts will have a larger impact on GDP growth than tax rises would.
• Second, policies affecting low earners have a higher multiplier than policies effecting high earners. So policies that take money away from lower earners will hit the economy harder than policies that take money from high earners. The reason for this is that low earners generally spend a lot more of their income than high earners (in economic terms, they have higher marginal propensity to consume). As high earners generally save a lot more of their income, they can better afford to absorb tax increases without cutting their day-to-day spending and reducing demand in the economy. 

This basic framework suggests George Osborne’s economics are doubly dangerous – not only is he planning close the deficit mainly through sending cuts rather than tax rises, but he is also planning on disproportionally hitting low earners through cuts to benefits.

Duncan Weldon is senior policy officer at the TUC and blogs at Touchstone.

• Posted by: Duncan Weldon at 9:56am on 22 December 2010
• Filed under: Economy

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