2.4. Fiscal Policy
Syllabus Content
- The government budget - Sources of government revenue; Types of government expenditures & the budget outcome
- The role of fiscal policy - Fiscal policy and short-term demand management; The impact of automatic stabilizers; Fiscal policy and its impact on potential output & evaluation of fiscal policy
The government budget - Sources of government revenue; Types of government expenditures & the budget outcome
Explain that the government earns revenue primarily from taxes (direct and indirect), as well as from the sale of goods and services and the sale of state-owned (government-owned) enterprises.
Sources of government revenue
In order to provide all the goods and services governments are expected to provide they need funding. Whether this is directly providing health, education, security (eg police, army, fire department etc) or subsidising merit goods (solar energy, pharmaceuticals, research and development, The Arts etc) they need to raise (collect) revenue.
Taxes
Tax systems include direct taxes (income tax, profit tax, capital gains etc) and indirect taxes (sales taxes - VAT, GST; excise taxes - tobacco, alcohol, import)
Sale of Goods and Services
When governments own and run enterpises (usually utilities) they charge for the goods and services they sell (eg electricity, gas, clean water) and there are charges for non-utilities such as museums, national parks, toll roads etc).
Explain that government spending can be classified into current expenditures, capital expenditures and transfer payments, providing examples of each.
Types of government expenditure
So government spending or government expenditure is often divided into three main types:
• Current Expenditures or Government final consumption expenditure on goods and services for current use to directly satisfy individual or collective needs of the members of the community.
• Capital Expenditures or fixed capital formation (or government investment) - government spending on goods and services intended to create future benefits, such as infrastructure investment in transport (roads, rail airports), health (water collection and distribution, sewage systems, communication (telephone, radio and tv) and research spending (defence, space, genetics).
• Transfer payments - spending that does not involve transactions of goods and services, but instead represent transfers of money, such as social security payments, pensions and unemployment benefit.
Distinguish between a budget deficit, a budget surplus and a balanced budget.
The government budget is a statement that sets out all revenue streams coming into the government treasury departments and all the expenditures made by the government (or public sector, which includes municipal and local government as well as national government).
There can be a
• Budget deficit (expansionary on the economy because spending - injection- is greater than tax revenue - withdrawal).
• Budget surplus (contractionary on the economy because spending - injection- is less than tax revenue - withdrawal)
• Budget balance - although one would perceive a balanced budget to have no net effect on the economy, it is actually stimulatory. This is because of the spending multiplier i.e. an injection of government spending (or investment) will have a disproportionate increase in real GDP.
Task 1: From observing the charts above, please identify three implications of the figures (Think in terms of budgetary position, sources of revenue & expenditure and future prospects for the Hong Kong economy).
Task 2: Explain why in the United States total government (Federal, state and local) spending account for about 30% of GDP, while total government purchases are only about 20% of GDP.
Understanding government's income
Where does the government get money from?
Where do you tax dollars go?
The budget outcome
Distinguish between a budget deficit, a budget surplus and a balanced budget.
• Budget deficit exists where government income from taxation is less than government spending: R<T
• Budget surplus exists where government income from taxation exceeds government spending: R>T
• Balanced budget exists where government income from taxation equals government spending: R=T
Fiscal stance refers to the position the government is taking with regard to operating a budget deficit, budget surplus or a balanced budget. Whilst you may think that it would be common sense for a government to always run a budget surplus or a balanced budget, there may be very good reasons for it to deliberately choose to operate a budget deficit (Keynesian expansionary policy)
Explain the relationship between budget deficits/ surpluses and the public (government) debt.
National debt refers to the total amount that the government has borrowed over time as a consequence of operating budget deficits.
• This is a great site to show you the extent of the USA National Debt Watch it increasing by the second.
• How much is Brazil's national debt?
Clearly, if there is a budget deficit the national debt is increased by that amount (because extra spending must be financed by borrowing if it does not come from tax revenue).
A budget surplus reduces the national debt
• Public sector borrowing requirement (PSBR) is where total government income (tax revenue and income from public corporations) is less that government spending. It is largely made up of the budget deficit. In such cases, the government has to borrow money to finance the short fall. It can do this by selling national savings certificates and securities such as gilts or treasury bills and bonds.
• Public sector debt repayment is where total government income (tax revenue and income from public corporations) is greater than total government spending. In such cases, the government can repay some its previously accumulated national debt.
Task 3: Hong Kong Budgetary Position
a) Identify one possible reason for the budgetary position in the following years
1. 1999
2. 2002
3. 2007
4. 2008
b) In the event of a budget deficit, identify how this could have been financed.
c) Explain the relationship between budget deficits and the national debt
d) Suppose you are an economic policy adviser to the Hong Kong Chief Executive and he or she asks for your recommendation to eliminate a budget deficit. What would you recommend?
Task 4: Suppose the percentage of national debt owned by foreigners increases sharply. Why would this trend concern you?
Task 5: Suppose the government has no national debt and spends US$100 billion while raising only US$50 billion in taxes.
(a) What amount of government bonds will the US Treasury issue to finance the deficit?
(b) Next year, assume that tax revenues remain at US$50 billion. If the government pays a 10% rate of interest, add the debt-servicing interest payment to the government’s $100 billion expenditure for goods and services the second year.
(c) For the second year, compute the deficit, the amount of new debt issued, and the new national debt.
Task 6: Explain this statement: ‘The national debt is like taking money out of your left pocket and putting it into your right pocket’
Fiscal Policy: the relationship between budget deficits, surplus and national debt
Does [the US]government have a revenue or spending problem?
What can we cut to balance the budget?
Explain how changes in the level of government expenditure and/or taxes can influence the level of aggregate demand in an economy.
Fiscal Policy can:
- Boost the level of economic activity if there is a shortage of demand, which is causing a deflationary gap. In this case, it is called reflationary policy.
- Reduce the level of economic activity if too much demand in the economy is causing an inflationary gap. In this case, a deflationary policy is appropriate.
- Be a supply-side policy, used to improve incentives, e.g. through income tax cuts, or to improve the quality of resources, such as increased government expenditure on health and education and subsidies to key areas.
Aggregate Demand and Budgets
The AD curve is shifted by changes in the components of AD (C+I+G+X-M). Therefore, the government can attempt to influence the level of Real GDP produced and in turn affect government objectives: inflation, unemployment, economic growth.
Reflationary or expansionary fiscal policy (Shifting AD to the right)
Governments may choose to employ reflationary or expansionary fiscal policy in times of recession or a general downturn in economic activity. In this situation, they will use fiscal policy to stimulate the economic activity. They may do this by lowering taxes (withdrawals) in some form or by increasing government expenditure (G - injection).
If they lower indirect taxes, then this will lower the prices of the taxed goods and encourage more consumption expenditure (C).
Alternatively, they could lower direct taxes increasing disposable incomes (take-home pay) and encouraging greater consumption (C). Either way the level of demand in the economy should rise and stimulate economic growth.
Reflationary fiscal policies can include:
• Cutting the lower, basic or higher rates of tax
• Increasing tax-free allowances
• Increasing the level of government expenditure
The effect of these policies should be to boost aggregate demand and the equilibrium level of income.
First, remember a deflationary gap (Keynesian) is when equilibrium (Y) Real GDP is lower than Full Employment Real GDP (asa shown in the digram on the left). The government may choose to use a reflationary policy to shift AD to the right and bring the economy closer to Full Employment (Yf).
Construct a diagram to show the potential effects of expansionary fiscal policy, outlining the importance of the shape of the aggregate supply curve.
However, reflationary policy may cause demand-pull inflation. Keynesians would argue that reflationary fiscal policy is appropriate where there is spare production capacity (demand deficient unemployment) as they believe that the economy can settle at any equilibrium level of output. Their view of reflationary policy can be seen in Figure 2 below.
Reflationary policy shifts AD to the right but the closer to full employment (vertical section of AD) the more the effect will be on the price level rather than on Real Output (Real GDP).
For Keynesians, any increase in AD on the horizontal section of the AS curve will not be inflationary because there will be spare resources firms can use to increase output without increasing costs of production. Prices will only increase when the economy approaches full employment and can only be inflationary as the AS curve becomes vertical.
Introduction to Fiscal Policy
Deflationary fiscal policy (Shifting AD to the left)
Explain the mechanism through which contractionary fiscal policy can help an economy close an inflationary gap.
Deflationary fiscal policy is likely to be most appropriate in times of economic boom (remember business cycle). If the economy is growing at above its capacity (short run Peak or Boom), this is likely to cause inflation and balance of payments problems.
To slow the growth of the economy, the government could increase taxes in some form and/or reduce government expenditure. Either of these should reduce the level of demand in the economy and, therefore, the level of economic growth. The government may increase indirect taxes, which will result in higher prices for goods and services if firms maintain their profit margins. This should deter consumers from purchasing the same quantity of goods and services. Alternatively, the government may increase direct taxes, which will leave people with less money in their pockets and discourage spending.
Construct a diagram to show the potential effects of contractionary fiscal policy, outlining the importance of the shape of the aggregate supply curve.
Deflationary fiscal policies include:
• Increasing the lower, basic or higher rates of tax
• Reducing the level of personal allowances
• Reducing the level of government expenditure
The effect of these policies will be to shift the aggregate demand curve from AD1 to AD2, as in Figure 4 above, to return to Full Employment.
Summary of effects of fiscal policies using the Neo-Classical model
I have used the new-classical model above to illustrate the effects of fiscal policies on inflationary and deflationary gaps. The Keynesian model yields other possibilities and insights, as seen in the figure below. Four possible outcomes of fiscal policies arise depending on where macro equilibrium is initially:
1. Low levels of income and high unemployment (Y0) would give rise to expansionary fiscal policies (AD0 to AD1) which would increase income without inflation.
2. Approaching full employment (YFE), firms encounter bottle-necks in supply and diminishing returns – costs rise. Fiscal stimulation at Y2 or Y3 will increase income and decrease unemployment but the trade-off is increased inflation (P2 to P3) in the economy.
3. Fiscal stimulus at YFE will be purely inflationary as the economy is utilizing all factors of production maximally and any increase in AD has no effect on real GDP.
4. Deflationary policies undertaken at P4 and YFE will decrease inflation without causing a decrease in real GDP or a rise in unemployment (AD5 to AD4).
The shape of the Keynesian aggregate supply curve has some rather important ramifications for fiscal policy. The first is that government can ‘choose from a menu’ of possible inflationary and real income levels. The second is that governments must accept that there will be trade-offs in setting an unemployment or inflation target. And finally, as will be seen below, Keynesian theory puts forward that supply-side policies are ineffective at very low levels of income (say at Y1 or below) since the increase in AS does not have any effect on equilibrium income.
Deflationary fiscal policy
Long-run macroeconomy - inflationary & deflationary gaps part 1
Long-run macroeconomy - inflationary & deflationary gaps part 2
Impact of automatic stabilisers
"Automatic stabilizers are features of the tax and transfer systems, that tend by their design to offset fluctuations in economic activity without direct intervention by policymakers. When incomes are high, tax liabilities rise and eligibility for government benefits falls, without any change in the tax code or other legislation. Conversely, when incomes slip, tax liabilities drop and more families become eligible for government transfer programs, such as food stamps and unemployment insurance, that help support their income."
Source: http://www.taxpolicycenter.org/briefing-book/background/stimulus/stabilizers.cfm
When the economy starts to ‘heat up’ , a number of stabilising effects will automatically kick in – mechanisms which are built-in to the economic system and social welfare system.
Government spending in the form of social benefits is one such stabiliser. An increase in economic activity and GDP will see lower unemployment levels and serve to lower the need for
social benefit payments such as unemployment benefits, income-based housing allowance and so forth. This lowers disposable income for households on the receiving end of benefits.
The other stabiliser, taxes, influences net income (income after tax) of households and therefore their consumption. Most countries have some element of progressive income taxation, meaning that the percentage paid in income tax increases when gross personal income rises. When household incomes rise during a boom period, around t0 in figure I , either due to overtime, new jobs or wage increases, many wage earners will move into higher income brackets and thus pay a larger proportion of their take-home pay in tax.
Taken together in the macro environment, lower social benefits and higher proportionality of taxes paid both serve to lower net disposable income in the economy and therefore consumption. Since both social benefits and progressive income taxes are built into the economic and social system, the braking effect on aggregate demand, shown by the downward readjustment from AD1 to AD2 in diagram II, is automatic. The effect is that aggregate demand falls less than otherwise would be the case, cutting the peak of the business cycle.
During recession, around t1 in diagram I , the effect of automatic stabilisers helps dampen the fall in economic activity.
• When incomes fall and unemployment rises, falling marginal tax rates mean that tax burdens on households will decrease. This stimulates consumption.
• Lower AD and lower real GDP is associated with increased unemployment. Hence unemployment and social benefits will also increase in the economy. This has a positive effect on households’ spending which helps to limit the decrease in aggregate demand. This can help lessen the severity of a downturn/recession.
This is shown by the upward readjustment from AD1 to AD2 in diagram III . (Remember; unemployment benefits and transfer payments are NOT included as elements of GDP, as this would cause double counting.
However, when these transfer payments help to bolster consumption and thus aggregate demand, there is a positive effect on GDP.)
The effect of automatic stabilisers over time is that the swings in economic activity, the amplitude of real GDP cycles, are somewhat milder than without, shown by the blue cycle in figure I . Note that automatic fiscal stabilisers do not solve recessions or overheating but merely lessen the impact of them somewhat.
Task 7: In each of the following cases, explain whether the fiscal policy is expansionary, contractionary or neutral.
(a) The government decreases government purchases
(b) The government increases taxes
(c) The government increases purchases and taxes by an equal amount.
Automatic stabilizers in fiscal policy
Task 8: Expansionary Fiscal Policy (HL only)
The Government Spending Multiplier:
I. Assume the economy of Switzerland is experiencing a slump in aggregate demand, and output in the economy is thought to be $10 billion what would be produced at full employment. On the graph below, illustrate the Swiss economy at its current level of output.
I. On the graph you drew above, identify the recessionary gap.
II. Assume that the Swiss government wishes to enact a fiscal policy that would return the economy’s output to its full employment level. Identify the options available to the Swiss government.
III. The Swiss government is considering increasing government expenditures by $2 billion. The government has determined that at present, a $2 billion increase in household income will have the following effects:
· $1.2 billion would be spent on domestically produced goods and services
· $800 million would be saved or otherwise leaked from the nation’s economy
Calculate the following for Switzerland:
a. The Marginal Propensity to Consume (MPC)
b. The Marginal Rate of Leakage (MRL)
IV. Using the results from your calculations in #4, determine the size of the government spending multiplier in Switzerland. Explain the relationship between the “marginal propensities” you found above and the government spending multiplier.
V. Calculate the effects of the proposed $2 billion spending package. Will it be large enough to achieve the $10 billion increase in output and national income that the government wishes to achieve? Why or why not?
VI. Calculate the minimum increase in government spending that could bring about full employment assuming the marginal propensities remain at the level you calculated in #4?
VII. Assume that several economists have determined that the MPC among Swiss households is actually much higher, at 0.8. How large an increase in government spending would be needed to fill the recessionary gap if this estimate were correct? Show your calculations.
Fiscal Policy - government spending multiplier
Fiscal Policy - tax multiplier
Explain that fiscal policy can be used to promote long-term economic growth (increases in potential output) indirectly by creating an economic environment that is favourable to private investment, and directly through government spending on physical capital goods and human capital formation, as well as provision of incentives for firms to invest.
Long Term Economic growth is depicted as a shift in LRAS to the right (ie an increase in the production potential of the economy or full employment real GDP)
Supply-side policies are policies that aim to increase the capacity of the economy to produce. However, it is also possible for fiscal policy to act on the level of supply and government will often use fiscal policy as one of their key supply-side policy tools.
Income tax may have an effect on people's incentives to work. This will be true at most income levels. If income tax at low-income levels is too high, people may choose to remain unemployed, or not to seek, employment. This is an economically rational decision, because it may be more rewarding to stay on benefits when other expenses of employment, such as transport and childcare, are factored in. This situation is often referred to as a 'poverty trap', because the unemployed cannot improve their financial position.
If income tax on high levels of income is too high, people (Entrepreneurs) may choose not to work so hard or take risks. Ultimately, they could make the choice to leave a particular country if taxes in other countries are significantly lower This 'flight' out a country to seek lower taxes elsewhere is called a 'brain drain', when the process involves large numbers of the most talented and skilled in a population.
Supply-side fiscal policies can include:
• Cutting the lower and basic rates of tax to open up the gap between the earnings in work and the benefits of those who are unemployed, to ensure people have an incentive to work
• Increasing the level of tax-free personal allowances for the same reason
• Reducing the top rate of tax to encourage enterprise, risk-taking and the incentive to work harder
1 Government spending on health and education and infrastructure such as roads and railways.
The intended effects of these supply-side policies are known as 'microeconomic effects' although bear in mind that they may have macroeconomic effects as well.
In a nutshell, free market economists favour using fiscal policy as a means of affecting incentives (Long Run) while Keynesians favour using fiscal policy to directly affect economic activity through Aggregate Demand (Short Run).
Fiscal supply-side policies
Supply-side fiscal policies
Evaluate the effectiveness of fiscal policy through consideration of factors including the ability to target sectors of the economy, the direct impact on aggregate demand, the effectiveness of promoting economic activity in a recession, time lags, political constraints, crowding out, and the inability to deal with supply-side causes of instability.
Evaluate the effectiveness of fiscal policy through consideration of factors including:
• the ability to target sectors of the economy,
• the direct impact on aggregate demand,
• the effectiveness of promoting economic activity in a recession,
• time lags,
• political constraints,
• crowding out, and
• the inability to deal with supply side causes of instability.
The effectiveness of fiscal policy, as a measure to influence aggregate demand and output, is open to much debate.
The argument over using fiscal policy revolves around whether:
• It can be used as a fine tuning mechanism
• It can be used to achieve the desired level of national income
• It can be used to reduce unemployment without causing overheating and inflation
• The 'right' levels of government spending and taxation be determined
• Changes in government spending and taxation can be offset by changes in other injections and leakages
• Time lags between changing policy and the effects are too long for the desirable results to be estimated or achieved
• An increase in aggregate demand will necessarily lead to an increase in output income and employment
• Expansionary fiscal policy will have any undesirable effects, such as inflation, worsening the balance of payments situation or ' crowding out' private borrowing and investment
Major arguments in favour of fiscal policy
- Increasing aggregate demand through changing government spending and taxation will increase output, employment and income, in the short run, working through an expenditure multiplier process.
- Target sectors of the economy - Fiscal policies can target specific industries, regions and labour groups – and often all three since there is a considerable overlap (revise structural unemployment in Chapter 51). For example, the labour government in the UK during the 1960’s and ‘70’s used numerous demand-side measures to lower unemployment levels. Nationalised industries (steel and coal) helped bolster demand for labour as did the increasing size of the government provided health care (National Health Service). Other methods (look up Japan for this one!) have often been large infrastructure projects to create jobs in under-developed areas. Keynes himself wrote about how job creation as a result of fiscal policies could be directed towards lagging urban or rural areas.
- Macro goals - By adjusting monetary and fiscal policies, it is possible to influence the level of economic activity and therefore output, unemployment, inflation and the trade balance. In other words, demand management gives politicians tools to achieve the macroeconomic goals of society. In addition to this, the built-in fiscal stabilisers – automatic stabilisers – help even out the economic cycles and create stability and predictability in the economy, while evening-out some of the excesses/surpluses in productive capacity over time.
- Promoting economic activity during recessions - Discretionary fiscal policies in turn allow governments to steer the economy in line with both consensus views of economic goals and ideological underpinnings and ideals of social/economic welfare. Full employment increases living standards while tax rates, unemployment benefits and government spending all help in improving social welfare systems and redistributing incomes in the economy. Note that the concepts such as ‘fairness’ and ‘equality’ are NOT entirely normative. There are in fact a good many sound economic arguments underlining social redistribution by way of taxes and transfer payments, in that a great many economic and social costs show strong positive correlation to increased inequality of income and wealth; crime, alcoholism and drug abuse are notable examples.
Major arguments against fiscal policy
Fiscal policy - weaknesses
• Time Lags- changes in direct taxes may take considerable time to implement and government spending is often inflexible in a downwards direction; e.g. for political or moral reasons, it is usually difficult to reduce government spending on pensions and benefits and once a capital project such as a motorway has been started, it is difficult, if not impossible, to stop it in mid-stream.
· Conflicts between objectives - fiscal policy designed to achieve one goal may adversely impact on another. For example, reflationary fiscal policy designed to stimulate aggregate demand and reduce unemployment may worsen inflation (N.B. for HL students only, this is explained in greater detail in the extension section on the long run Phillips curve).
· Neo-Classical critique
I. Inflation vs long-run growth - Classical economics points to the stagflationary (= rising inflation and low/falling GDP) demand-side period of the 1970s and the period of price stability and growth of the supply-side 1980s. Demand-side policies ultimately failed quite drastically in balancing budgets over a cycle, as deficit spending during recessions was never countered during boom periods. Demand-side policies therefore have their place in combating inflation, not in increasing output, according to the new-classical view. New-classical economists put heavy emphasis on using supply-side policies rather than demand-side policies to increase long run growth.
II. Demand-side policies lessen efficiency - Another basic premise of the new-classical school is the inter-temporal opportunity cost issue of demand management, where demand-side policies focusing on alleviating unemployment will have far greater long run costs when inflationary pressure not only dissolves any short run gains in income, but where resources are squandered (= wasted) on inefficient government spending. The interventionist leaning of demand management distorts factor markets and inhibits market clearing. The new-classical school prescribes the use of production incentives such as lowering corporate taxes and labour incentives such as decreasing
III. Crowding out - Many economists argue that the government should aim, as a policy objective, to minimize the level of government borrowing and should not increase its spending if this means borrowing to do so. If the government borrows heavily, it will have to compete for funds with private sector firms, which want to borrow to invest themselves. This competition for funds will push up interest rates. Higher interest rates mean that firms will be less willing to invest and individuals may even be more reluctant to borrow to spend. This process is described as government expenditure 'crowding out' private borrowing. In its most extreme form, an increase in government expenditure will lead to an equivalent fall in consumption and investment (because of the higher interest rates) with the result that aggregate demand does not increase at all.
Economists debate how significant the effect of crowding out is and, as with most things, they rarely agree! (Keynesians generally argue that an increase in government spending, through the multiplier process, will crowd in private consumption and investment).
Supply-side economists believe that certain fiscal measures will have a disincentive effect. For example, an increase in income tax may adversely affect the supply of labour; an increase in profits tax may adversely affect the incentives of firms to invest and an increase in welfare benefits may adversely affect incentives to seek employment.
If the problem is one of unemployment, changes in taxation and particularly government spending may have a significant impact on the level of national income through the increase in aggregate demand that they cause. Fiscal policy therefore may be very effective in reducing demand-deficient unemployment. (N.B. For HL students only, the effectiveness of fiscal policy in combating unemployment may be explained through the operation of the multiplier effect. This is dealt with in the HL extension section that follows).
Fiscal policy may also succeed in shifting the LRAS curve to the right, increasing real output and reducing the rate of inflation. This may work via greater government spending on education and training and tax cuts, which improve incentives to work and invest.
As will be seen in Section 2.3, fiscal policy may be used to alter the distribution of income and wealth within an economy. Greater emphasis on direct, progressive taxes and benefits to the less well-off make the distribution more equal. The opposite effect will be achieved through a shift towards indirect, regressive taxes and cuts in benefits for the less well-off.
Section 2 of the course showed how fiscal policy can be used in a selective way, for example, to:
• Increase consumption of merit goods through subsidies and direct government provision
• Decrease consumption of demerit goods and imports through taxation
• Increase consumption of public goods
Evaluation of Fiscal Policy
Introduction to fiscal policy
Evaluating fiscal policy part 1
Evaluating fiscal policy part 2
Fiscal policy: The best case scenario
Fiscal policy and crowding out
Econ Duel: Does fiscal policy work?
The dangers of fiscal policy
The limits of fiscal policy
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