The fiscal multiplier is used to determine how much a change in government spending or tax policy increases or decreases an economy's gross domestic product (GDP).
The government has two tools to implement fiscal policy: taxing and spending. Spending programs differ in how much they affect the GDP. Likewise some taxes have a greater impact on the GDP than others. The fiscal multiplier is used by economists to try to quantify how a given spending or tax policy will ultimately impact GDP.
Assume Zoey’s Manufacturing receives a government contract of $5 million. When a household or business receives money, it will spend some and save some. How much consumers spend can be estimated using the marginal propensity to consume (MPC). The MPC is the percentage of a consumer’s disposable income that is used to purchase consumer goods or services. It is needed to calculate the fiscal multiplier effect and resulting increase in GDP.
The formula for the fiscal multiplier is:
Fiscal Multiplier = 1 / (1-MPC)
If the MPC equals 70 percent, then the multiplier equals 3.33. To illustrate its impact on the economy, let’s return to the $5 million investment. In the first round, the $5 million purchase from Zoey's Manufacturing is channeled directly into the economy, so it would generate a $5 million increase in the economy’s GDP. In the second round, workers and the company would spend $3.5 million ($5 million x 0.7) and save $1.5 million. After two rounds the $5 million investment has contributed $8.5 million to the GDP. But the cycle doesn’t stop after two rounds. In theory, the contribution to GDP will eventually reach $16.67 million ($5 million x 3.33).
Anything that changes the marginal propensity to consume directly influences the multiplier. Income affects a consumer’s MPC. Generally, lower income individuals are less able to save, a fact that can influence fiscal policy. For individuals with lower incomes, a windfall of money is more likely to be spent on seeking medical help, repairing a vehicle, or purchasing new clothes—all expenditures they may have delayed prior to having an increase in income. In contrast, more affluent consumers are more likely to save extra income. As a result, tax policies that benefit wealthier people have less of an immediate impact per dollar than tax policies focused on helping the less affluent. (Some tax policies that promote investment may have a larger long-term impact on economic growth.) For example, economist, Mark Zandi in 2012 estimated that in the first year the multiplier would have been 0.39 if Congress had made the reduction in dividend and capital gains taxes permanent. Mr. Zandi estimated that a temporary increase in food stamps had a multiplier of 1.71. The reason for the difference was recipients of food stamps were more likely to spend the money immediately than wealthier individuals would spend the savings accrued from the reduction in the capital gains and dividends taxes. Mark Zandi concluded tax policies that had a higher MPC should have been used to help the economy recover from the Great Recession. (Mark Zandi's testimony before the Joint Economic Committee February 7, 2012.)
Government purchases increase the aggregate demand more than a transfer payment or tax reduction. Money invested by the government immediately enters the economy. In subsequent steps, consumers save a portion and spend the rest. The amount consumers spend depends on their MPC. Consumers will save a portion of the transfer payment and those savings are not used immediately to increase aggregate demand. To illustrate, assume the government must choose between purchasing a $5 million office building or increasing transfer payments to elderly citizens. Assume the average marginal propensity to consume is 70 percent. If the government purchased the building, $5 million would enter the economy immediately. Of the $5 million, $3.5 million would be spent and $1.5 million would be saved. After two rounds of spending and saving, $8.5 million would enter the economy to increase aggregate demand.
If the government chooses to make a transfer payment, the recipients would choose to spend $3.5 million and save $1.5 million. In the second round of spending, the consumers receiving the $3.5 million would spend $2.45 million ($3.5 million x .70), and save $1.05 million. Consumer spending and aggregate demand would only increase $5.95 million after two rounds. Direct purchases by the government increase aggregate demand more than transfer payments or tax reductions.