Economics 103: Can Government Spending Spur the State’s Economy When the State’s Budget Must be Balanced?

 

By Rick Olson, State Representative, District 55
June 11, 2011

A question we often hear from members of interest groups whose state funding is being reduced is, “How can we expect to create jobs if we cut spending for our _______ program when positions need to be cut? Aren’t we cutting the number of jobs rather than cutting unemployment?”

We also hear, “Governor Snyder cannot guarantee a single job will be created with the elimination of the Michigan Business Tax and substituting the 6% corporate income tax.”

A rudimentary understanding of macroeconomics is needed to understand why we have done what we have done and/or are doing with the recent changes in the taxes and spending in the state.

The sum of all economic activity in a country or state can also be called aggregate demand.

“In macroeconomics, aggregate demand (AD) is the total demand for final goods and services in the economy (Y) at a given time and price level. The aggregate demand is usually described as a linear sum of four separable demand sources.

where

  is consumption (may also be known as consumer spending)

  is Investment,

  is Government spending,

( – ) is Net exports, where is total exports, and is total imports”

http://en.wikipedia.org/wiki/Aggregate_demand All of the interacting factors gets complicated, but let’s simplify the model by assuming investment and net exports remain the same, such that for a given period changes in AD are only affected by changes in consumption and government spending. For the purposes of this discussion, we will also consider this a static model, without any consideration of indirect or extraneous interactions.

“The Government may increase its expenditure e.g. financed by a higher budget deficit, - this directly increases AD. Income tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption. An increase in transfer payments raises AD – particularly if welfare recipients spend a high % of the benefits they receive.” http://tutor2u.net/economics/revision-notes/as-macro-aggregate-demand.html

However, in a state like Michigan in which the state’s budget must be balanced, a budget deficit cannot occur (in the absence of use of “one-time money, accounting gimmicks, or bonding for projects) and therefore the state’s AD cannot be raised by deficit financed government spending. The government spending must be financed by taxes extracted from the state’s economy. The collection of $1 billion of taxes reduces AD the same amount as the $1 billion of government spending increases the state’s economic activity. I.e., “consumption is a function of disposable income. If disposable income decreases, consumption will also decrease. There are many ways that consumption can decrease. An increase in taxes would have this effect.” http://www.sparknotes.com/economics/macro/aggregatedemand/section3.rhtml

The reason the counterbalancing reduction in economic activity is seldom considered is (1) it is not in the self-interest of the affected interest group to tell the whole story (i.e., “the truth”) and (2) while the jobs created by the government spending are clearly identified, the equivalent number of jobs lost by the collection of taxes are diffused throughout the economy in bits and dribbles.

Guarantee Jobs Due to Business Tax Cut? Because the positive job effect of a reduction in taxes is also so diffused throughout the economy, it is also impossible to directly identify the jobs created by a tax cut. Thus Governor Snyder says he can’t guarantee the jobs being created, because he could never point to any specific job created as proof of his assertion. Based on the aggregate demand model, however, we know the economic activity will occur. Further, we expect the better business climate to create greater incentives for local businesses to expand and create jobs and also to make the state more competitive in attracting business to the state. These, however, are indirect effects of the taxation levels, caused by the changed incidence or location of the tax collection which will be in addition to the AD effects of the tax cut for businesses that are not C corporations.

What About Multiplier Effects? There is also the possibility that a change in government spending accompanied by an equivalent counteracting change in taxation may change AD, the level of economic activity in the state. This is if the “multiplier” of the government spending is different from the multiplier of the taxation. The multiplier is the number of times a change in government spending (or taxes collected which is then not spent on consumption) rolls over in an economy. This is similar to the analysis of tourism spending in the state, which is first spent on a motel room, then the motel owner pays his or her workers, then the workers spend their money on food, etc., the supermarket owner spends his money on its supplies, etc., etc. The number of cumulative times the money turns over in a defined area economy (such as the State of Michigan) depends on the leakage out of the economy on each of the successive transactions. Examples of leakage would be the motel owner buying new furniture from out of state with the money received, or the supermarket buying produce from some other state, or the worker saving some of the money instead of buying something. I am not aware of any studies that have evaluated the multiplier effect of welfare payments, vs. that of wages and benefits for state employees, vs. that of wages and benefits of teachers, vs. that of taxes extracted from small businesses, vs. taxes extracted from seniors with incomes above the poverty level. Thus I have no basis for saying that the basic balancing of the government spending and the tax collections have any positive or negative direct effect on the level of economic activity within the State of Michigan.

Political Impact of Arguments. Of course, this erudite conclusion does not have the political impact of the negative sound bites currently be spewed by those negatively affected by the restrained government spending which the Michigan Legislature just enacted. Those who know this, however, and still spew the negative sound bites should know that they are spreading half-truths, and half-truths spread with the intention to misinform or cast a legislator in a negative light are as much lies are bald-face lies. No matter how you look at it, a liar is a liar.