Balance Budget Factor

Balanced budget means change in government expenditure is exactly matched by a change in taxes. Classical economists believed that a balanced budget is neutral in the sense that the levels of output or income remain unchanged. However, Keynes and his followers proved that balance budget is expansionary. The expansionary effect of a balanced budget is called the Balanced Budget Multiplier ($BBM=K_{B}$) or Unit Multiplier. Here an increase in government spending matched by an increase in taxes results in a net increase in income by the same amount. Let $MPC$ is marginal propensity to consume, $K_{G}$ is government spending multiplier and $\Delta G$ is Government expenditure then change in output is given by

$\Delta Y=K_{G}\times \Delta G={\frac {1}{1-MPC}}\times \Delta G$

Assume that $MPC$ is $0.75$ and government increases expenditure by Rs. 20 then national income will be increased by Rs. 80. If government applied taxes ($\Delta T$) of same amount, i.e. Rs. 20, $K_{T}$ is tax multiplier effect then the output shall be

$\Delta Y=K_{T}\times \Delta T={\frac {-MPC}{1-MPC}}\times \Delta T$

and in this case it is Rs. 60. This happens due to the decline in consumption to Rs. 15 with increase in taxes of Rs. 20. The decline in consumption ($\Delta C$) is not equal to Rs. 20, since

$\Delta C=-MPC\times \Delta T$

Reduction in consumption by Rs. 15 leads to a decline in income by Rs. 60. As a result, the net increase in national income becomes Rs. 20 (Rs. 80 - Rs. 60). Thus, increase in net income of Rs. 20 caused by an increase in government spending of Rs. 20, and increase in taxes of Rs. 20 all are equal, i.e. ratio is 1. This result is known as the balanced budget theorem or unit multiplier theorem.

References

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