According to many economic experts and commentators, an effective way to generate economic growth is through the lowering of taxes. The lowering of taxes, it is held, is going to place more money in consumer’s pockets thereby setting in motion an economic growth. This way of thinking is based on the popular view that a given dollar increase in consumer spending will lift the economy’s gross domestic product (GDP) by a multiple of the increase in consumer expenditure. An example will illustrate the magic of this multiplier.
Let us assume that on average individuals spend 90 cents and save 10 cents of each additional dollar they receive. If consumers raise their spending by $100 million this will boost retailers’ revenues by this amount. Retailers in turn will spend 90% of their new income, i.e. $90 million on various goods and services. The recipients of the $90 million will in turn spend 90% of $90 million i.e. $81 million and so on. At each stage in the spending chain, people spend 90% of the additional income they receive. This process eventually ends with the GDP rising by $1 billion i.e. (10*100million).
In short, all that is required is to give every individual more money to spend, and this in turn should set in motion increases in consumer expenditure, which in turn will trigger increases in the production of goods and services. Observe that within the framework of ‘the multiplier’ savings are actually bad news – since the more people save the smaller is the multiplier.
The magic of ‘the multiplier’ however, is just wishful thinking – a myth. Every activity in an economy has to be funded and therefore it is always in competition with other activities for scarce real savings. Hence, within all other things being equal if more is spent on consumption goods, then less is left for capital goods. An increase in retailers activity will be offset by the decline in the activity of capital goods producers.
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