Expansionary or contractionary fiscal policy need not take the form of changes in government purchases of goods and services. Governments can also change transfer payments or taxes. In general, however, a change in government transfers or taxes shifts the aggregate demand curve by less than an equal-sized change in government purchases, resulting in a smaller effect on real GDP.

To see why, imagine that instead of spending $50 billion on building bridges, the government simply hands out $50 billion in the form of government transfers. In this case, there is no direct effect on aggregate demand, as there was with government purchases of goods and services. Real GDP goes up only because households spend some of that $50 billion—and they probably won’t spend it all.

Table 13-1 shows a hypothetical comparison of two expansionary fiscal policies assuming an MPC equal to 0.5 and a multiplier equal to 2: one in which the government directly purchases $50 billion in goods and services and one in which the government makes transfer payments instead, sending out $50 billion in checks to consumers. In each case there is a first-round effect on real GDP, either from purchases by the government or from purchases by the consumers who received the checks, followed by a series of additional rounds as rising real GDP raises disposable income.

However, the first-round effect of the transfer program is smaller; because we have assumed that the MPC is 0.5, only $25 billion of the $50 billion is spent, with the other $25 billion saved. And as a result, all the further rounds are smaller, too. In the end, the transfer payment increases real GDP by only $50 billion. In comparison, a $50 billion increase in government purchases produces a $100 billion increase in real GDP.

Overall, when expansionary fiscal policy takes the form of a rise in transfer payments, real GDP may rise by either more or less than the initial government outlay—that is, the multiplier may be either more or less than 1 depending upon the size of the MPC. In Table 13-1, with an MPC equal to 0.5, the multiplier is exactly 1: a $50 billion rise in transfer payments increases real GDP by $50 billion. If the MPC is less than 0.5, so that a smaller share of the initial transfer is spent, the multiplier on that transfer is less than 1. If a larger share of the initial transfer is spent, the multiplier is more than 1.

A tax cut has an effect similar to the effect of a transfer. It increases disposable income, leading to a series of increases in consumer spending. But the overall effect is smaller than that of an equal-sized increase in government purchases of goods and services: the autonomous increase in aggregate spending is smaller because households save part of the amount of the tax cut.

We should also note that taxes introduce a further complication—they typically change the size of the multiplier. That’s because in the real world governments rarely impose lump-sum taxes, in which the amount of tax a household owes is independent of its income. With lump-sum taxes there is no change in the multiplier. Instead, the great majority of tax revenue is raised via taxes that are not lump-sum, and so tax revenue depends upon the level of real GDP. As we’ll discuss shortly, and analyze in detail in the appendix to this chapter, non-lump-sum taxes reduce the size of the multiplier.

In practice, economists often argue that the size of the multiplier determines who among the population should get tax cuts or increases in government transfers. For example, compare the effects of an increase in unemployment benefits with a cut in taxes on profits distributed to shareholders as dividends. Consumer surveys suggest that the average unemployed worker will spend a higher share of any increase in his or her disposable income than would the average recipient of dividend income. That is, people who are unemployed tend to have a higher MPC than people who own a lot of stocks because the latter tend to be wealthier and tend to save more of any increase in disposable income. If that’s true, a dollar spent on unemployment benefits increases aggregate demand more than a dollar’s worth of dividend tax cuts.