Government expenditures include:

• Transfer payments allow the government to redistribute income.
• The purchase of goods and services, such as spending on health, education, and defense.
• Capital expenditure, which takes a long time to formulate and plan.

Government revenues are generated through taxes.

• Direct taxes come from income, wealth, and corporate profits. This could include property tax and inheritance tax. Direct taxes are difficult to change without considerable notice. That is, they take longer to change.
• Indirect taxes include excise duties on fuel, alcohol, tobacco, and other items. They can have immediate impact and discourage unwanted behavior.

The four desirable attributes of a tax policy are:

• Simplicity (not easily manipulated)
• Efficiency (should not discourage work or investment or interfere with personal choices)
• Fairness
• Revenue sufficiency.

There is great potential for conflict between fairness and efficiency.

Multipliers

As disposable income increases, consumption expenditures increase, but by a smaller fraction than the increase in income. This is reflected in the marginal propensity to consume (MPC), which is less than one.

Marginal propensity to save (MPS) is defined as additional savings divided by additional current disposable income.

MPC + MPS = 1

If we add tax rate t, then:

MPC + MPS = 1 - t

An expenditure multiplier is the ratio of the change in equilibrium output relative to the independent change in consumption, investment, and government spending or spending on net exports that brings about the change.

The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. It exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.

The tax multiplier is the magnification effect a change in taxes on aggregate demand. An increase in taxes decreases disposable income, which decreases consumption expenditure, aggregate expenditure, and real GDP.

The two multipliers are called the fiscal multiplier: 1/[1 - c (1 - t)], where c is the MPC and t is the tax rate.

The balanced budget multiplier is the magnification effect of a simultaneous change in government purchases and taxes on aggregate demand. A $1 increase in government purchases increases aggregate demand initially by $1, but a $1 increase in taxes decreases consumption expenditure by less than $1 initially, so a $1 increase in both purchases and taxes increases aggregate demand.