Deficit Reductions and Multiplier Effects on the U.S. Economy

Written By: Xue Han
Luxembourg Garden Fellow, Global Infrastructure Asset Management LLC

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Written: January 30, 2012


A Quick Note

Xue Han's paper investigates how the "multiplier" will magnify the contraction of the U.S. economy due to the automatic budget cuts that the U.S. Congress has imposed. Voters in the U.S. and the leaders that they elect are engaged in a debate on how to allocate the public's resources that are increasingly constrained. Those who argue that investments in infrastructure will be critical to setting the economy on a more favorable trajectory will need to demonstrate that the multiplier for any public investment in infrastructure will multiply at a higher rate than the other alternatives for government expenditure.

-William Fitzgerlad

Preface

This research studies the effects of budget deficits reductions - the Automatic Budget Enforcement Procedures - on the overall economy in the U.S. over the next decade and report its detailed findings in the appended report.

As the Joint Select Committee ("super committee") announced failure in late November last year, the Automatic Budget Enforcement Procedures ("trigger cuts") of $1.2 trillion in total are expected to take place, imposing evenly distributed cuts of roughly $110 billion per year for nine fiscal years starting on January 2013.

Conclusion

The effects of provisions related to the Automatic Budget Enforcement Procedures on the overall economy are considerable. Over the 11-year horizon from 2013 to 2023, the budget cuts will reduce Gross Domestic Product by $1.86 trillion, or -5.2% on average and -7.6% at the most extreme point in 2021, when comparing to projections excluding such effects. The table below demonstrates the forecasted impact both annually and cumulatively during the time horizon of the budget cuts.

Summary of Methodology

Assuming for the Automatic Budget Enforcement Procedures, the report employs the IS/LM model to examine the effects of such fiscal spending cuts on each component of GDP, which enables us to adjust for decrease in government purchase, rather than an increase in most studies, and to account for the interest rate at the "zero-lower bound". The derived formula for estimating the fiscal multiplier is

 

 

With estimated marginal propensity to consume (c=0.85838), marginal propensity to import (n=0.2641) and average tax rate (t=0.1475), the calculated multiplier is 1.88.

With appropriate adjustments, the report takes advantage of the model by the Council of Economic Advisors (Romer-Bernstein model) for studying the lagging effects of the fiscal multiplier. Applying the accumulated multiplier effects of cuts in nine consecutive years featured by the Automatic Budget Enforcement Procedures and their compound impacts to the projections of GDP by the Congressional Budget Office, the report arrives at the adjusted projections as shown in the table below.