This variable is responsible for assessing the impact of public spending by the State on the country’s economy. It shows us how an increase or decrease in public spending or taxes affects the country’s total income. Next, we will see its interpretation, how to calculate it, and the abundant criticisms that economists have made about this variable.
How to interpret the tax multiplier
When trying to understand this term, whose calculation we will see a little later, it is essential to know that the fiscal multiplier can be interpreted in three ways, always depending on its value: equal to 1, less than 1, and greater than 1:
- Equal to 1. Suppose the fiscal multiplier is calculated, and the result is exactly 1. In that case, GDP increases by the same amount as public spending (if public spending increases by 1 million, GDP also increases by 1 million dollars).
- Less than 1. If the calculation is less than one unit, we will know that if public spending increases by one unit, the country’s GDP will increase by less than one unit.
- Greater than 1. Suppose the calculation of the fiscal multiplier is greater than unity. In that case, increasing public spending by one unit will increase the country’s GDP by a value greater than unity.
Evidently, in all the above cases, if what occurs is a reduction in public spending, the effect is reversed (GDP will decrease following the rules we have just seen).
Calculation of the tax multiplier
When trying to calculate the fiscal multiplier, a simple formula is used. It has its positive points (it serves as a good estimator that is simple and quick to calculate), but that does not measure the full impact of the fiscal policies carried out by a government. Something that has provoked much criticism and distrust in the economic sector. The formula to calculate the tax multiplier is as follows:
Mult. tax = 1 / 1 – c (1 – t)
- c (or MPC) = Marginal propensity to consume. It is a financial ratio, valued between 0 and 1, which indicates the part that citizens or companies dedicated to consumption when their income increases by 1 unit. If the value of this ratio is 1, it means that 100% of that amount is being used for the beneficiary’s consumption in an increase in income.
- t = Tax rate. The current percentage of taxes established by the government (that is, if you must pay 25% of the tax, we put 0.25 in the formula).
Example: Tax Multiplier Calculation
Putting into practice the calculation of the fiscal multiplier is very simple if you have the two values necessary to use the formula. Putting a case in which the current tax rate is 25%, and the marginal propensity to consume has a value of 0.66, the calculation of the fiscal multiplier of the country in question would be the following:
Tax multiplier = 1 / 1 – 0.66 (1 – 0.25) = 1.98
With this result, we can interpret that, for each unit that public spending increases, GDP will increase by 1.98 units. If the government increases public spending by 250 million euros, GDP will increase by $495 million (1.98 x 250).
Criticism of the utility of the fiscal multiplier
Although the calculation of the fiscal multiplier can become an excellent reason to apply specific fiscal policies to the economy of a country, there are indeed many doubts and criticisms when using it since, on many occasions, you can do erroneous or inaccurate calculations that seriously harm the economy of an entire nation.
We must bear in mind that, when calculating the PMC, aggregate values are used, which can complicate things and lead to the appearance of errors when obtaining the fiscal multiplier. In addition, the experience with this variable is not positive, something that we have seen after the economic crisis of 2008, where the IMF erroneously estimated the fiscal multiplier used to take the recovery measures, causing a serious paralysis in the economies, being the Greek case the most notorious and worrying.
Although many criticize the lack of reliability that governments or large economic entities have when applying the fiscal multiplier, this indicator offers an exciting representation of the variation in public spending on a country’s economic activities.
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