GDP = Consumption + Investment + Government Spending + (Exports – Imports)

Using that equation let’s examine what happens given certain circumstances.  First let’s assume that Government Spending (G) increases as a percentage of GDP (1).   In order for that to happen government must increase taxes.  Taxes are sourced from investment incomes, consumer incomes and business incomes. That results in less money available for consumers and businesses to spend and invest.  Now it is true that increasing G results in the purchase of goods and services from businesses, and those businesses employ consumers.  Admittedly, that does partially offset the reduction in income available for spending by Consumers and Businesses.  However, G is inefficient: some of the value of the money created by businesses and collected as taxes is lost due to the cost of administrative bureaucracy.  Furthermore, G consumes but does not create new value.  The overall result is a net reduction in GDP.  And paradoxically (or so it may seem), GDP contracts and less new income is created to be taxed.  Eventually, even though tax rates are increased, tax revenues decrease.

Now let’s consider what happens when government spending is reduced.  Because less money is required to operate the government, tax rates can be reduced.  That results in a larger percentage of GDP attributable to Consumer Spending, Business Spending, and Investment.  Increased Investment (2) creates new businesses (3), which creates more employment, resulting in more consumer income that can be spent (4) — spending, for example, on new products and services created via investment.  Note that this results in new value being created, causing  GDP to increase.  And oddly enough, even though tax rates are reduced (or at least not increased), tax revenues increase as GDP increases.

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