Understanding Fiscal Policy

Aims of Fiscal Policy (BUDGIE)

Fiscal Policy is the use of taxation and government spending in order to influence the overall levels of economic activity. For example, governments can increase the levels of direct or indirect taxation in order to reduce household incomes. On the other hand, through increasing debt, governments can increase spending in order directly boost the G component of Aggregate Demand and increase the real GDP and close a recessionary gap.

Business Cycle Fluctuations

Governments may use Fiscal Policy to reduce the extreme fluctuations in the overall levels of economic activity.

Unemployment

Governments may use Fiscal Policy to reduce the levels of unemployment through increasing spending in a recession to reduce cyclical unemployment or investing in education and training to reduce structural unemployment.

Distribution of Income

Governments may want to promote a more equitable distribution of income through higher taxation and redistributing the income through higher investment in merit goods such as healthcare or education or through direct transfer payments to lower income groups.

Growth

Governments may want to promote economic growth through fiscal policy. This can be both short term (closing recessionary gaps) or long term (increasing the production capabilities of the economy) through either lowing taxes or increasing spending.

Inflation

Governments may want to reduce inflationary pressures if the economy is experiencing demand pull inflation by increasing taxation and reducing spending (causing leakages to be greater than injections, thus reducing AD).

External Balance (Trade Balance)

Governments may want to influence the levels of imports into an economy in order to manage its trade balance. Importing more exporting is called a trade deficit, and whilst not necessarily a bad thing, must be funded through other methods, therefore governments may wish to reduce imports in order to have a sustainable balance of payments.

Sources of Government Revenue

Direct and Indirect Taxation

As we have seen previously, governments can raise revenue from either direct taxes (taxes directly paid on income, such as income tax or corporation taxes) or indirect taxes (taxes paid on a good or service, such as VAT, GST or IVA). This makes up the majority of a government budget.

The Sale of Goods and Services from State Owned Businesses

Another way a government can raise revenue is through revenue earned from businesses owned by the government. For example, Saudi Aramco is the largest (mostly) state owned oil firm in Saudi Arabia and the revenues from the sale and production of oil provides the government with over half its revenue.

The Sale of Government Assets

The final way a government can raise revenue is through the sale of government owned assets and firms. As is the case with a private individual, governments can sell off assets and firms (through the process of privatisation) in order to raise revenue. For example, the UK privatised many state owned industries in the 1980s and early 1990s, and whilst the main aim was to improve efficiency and not necessary revenue, the sale of these assets raised ￡34bn for the UK government revenues. The one problem with this approach however, is that sale of assets is limit and not a long term method of raising revenue.

Forms of Government Expenditure

Current Expenditure

Current expenditure is government's day to day expenditure. This could include salaries for public sector employees, supplies, costs of running schools and hospitals and other essential services.

In 2022-23, it is expected UK central government departments to spend £407.0 billion on the day-to-day (’current’) running costs of public services, grants and administration. This is 37 per cent of public spending. The biggest items are health (£167.9 billion), education (£77.0 billion) and defence (£32.4 billion).

Capital Expenditure

Capital Expenditure is the expenditure by governments on investments in physical capital or assets within the economy. The aim of this expenditure is to improve the capital stock of the economy through spending on physical capital, such as infrastructure to improve connectivity or productivity, or human capital through investment in healthcare and education (merit goods).

Transfer Payments

Transfer payments are one way payments made by the government to various groups in a society. For example, as we have seen previously, those living below the poverty line may be given transfer payments in order to prevent them entering into poverty. Or those unemployed may be given transfer payments in order to avoid experiencing poverty or other consequences of unemployment.

Expansionary and Contractionary Fiscal Policy

Expansionary Fiscal Policy

Expansionary fiscal policy is the process of lowering taxes and/or increasing government spending in order to stimulate the overall levels of aggregate demand (AD), increasing rGDP from Y1 to Y2 and closing a recessionary gap.

Lowering income taxes will increase households disposable income, encouraging households to increase spending and therefore increase the overall levels of consumption. (C)
Lower corporation taxes will increase firms after tax profits. These profits can be used by firms to invest in factors of production, such as increasing demand for labour or capital machinery, increasing business investment. (I)
Finally, governments can directly spend in the economy on goods and services in an economy with an increase in one of the above forms of expenditure (Current, Capital or transfer payments). All of these will increase Government Spending (G).

Reduction in overall levels of Aggregate Demand

Contractionary Fiscal Policy

Contractionary fiscal policy is the process of raising taxes and/or decreasing government spending in order to reduce the overall levels of aggregate demand (AD), decreasing rGDP from Y1 to Y2 and closing a inflationary gap.

Raising income taxes will decrease households disposable income, encouraging households to decrease spending and therefore decreasing the overall levels of consumption. (C)
Raising corporation taxes will decrease a firm´s after tax profits. As a result, firms will have less to be able to invest in additional factors of production and therefore, there will be a decrease in Investment (I).
Finally, governments can cut spending in the economy on goods and services in an economy decreasing Government Spending (G).

Long Run Impacts of Fiscal Policy

It is important to note that whilst fiscal policy is predominantly used to influence the overall levels of aggregate demand, the policies used can also have an impact on the Aggregate Supply of the economy in the Long Run. This depends on what policies are used. For example, increasing current expenditure or transfer payments will only increase the overall levels of aggregate demand in the short run as they increase injections into the economy.

However, an increase in capital expenditure by governments (for example building roads or schools and hospitals) will increase aggregate demand in the short run due to the increase in Government spending. These policies may also lead to an increase in the potential of the economy as they could lead to higher productivity and higher levels of human & physical capital, thus increasing the potential output of the economy. The same is true if the government cuts corporation taxes and firms increase investment in factors of production as a result.

Keynesian Multiplier

As we have previously discussed, Keynes believed that government spending is the only way to close a recessionary gap in the economy. One of the idea´s that underpinned his view was that of the multiplier. The Keynesian Multiplier is a concept that suggests an increase in government spending will actually create a ripple effect across the economy, in terms of increased government spending will lead to an increase in consumer expenditure as a result of the multiplier effect.

In order to understand the multiplier, we need to understand some key ideas:

Marginal Propensity to Consume (MPC) - The marginal propensity to consume is a measure of how much of an additional $1 households will spend when they recieve it.

Marginal Propensity to Save (MPS) - The marginal propensity to save is a measure of how much of an additional $1 households will save when they recieve it.

Marginal Propensity to Tax (MPT) - The marginal propensity to tax is a measure of how much of an additional $1 households will pay in taxes when they recieve it.

Marginal Propensity to Import (MPM) - The marginal propensity to import is a measure of how much of an additional $1 households will spend on imports when they recieve it.

The sum of the Marginal Propensity to Save + Marginal Propensity to Tax + Marginal Propensity to Import are collectively known as the Marginal Propensity to Withdraw.

If economy is in a recession, operating at Yrec, the Keynesian multiplier that the government does not need to spend the entire value of the recessionary gap (Yrec-Yfe) in order to close the recessionary gap. Instead in this case, the government needs only to spend (Y1-Yfe). This is called the autonomous spending. The real GDP will increase by the value of the government spending (+G). However, this injection in turn will cause an increase in consumption by the value of the multiplier and this is called the induced spending. The larger the multiplier, the higher the induced spending will be and therefore less government spending is needed. This is because there will be a higher marginal propensity to consume and households will spend more of the additional $1 they recieve, and therefore a higher amount of consumption, thus increasing the overall levels of Aggregate Demand more than the original amount of government spending.

Calculating the Keynesian Multiplier

There are two ways to calculate the Keynesian Multiplier:

The first method is to divide 1 by 1 minus the Marginal Propensity to consume.

The second method is to divide 1 by the marginal propensity to withdraw. The MPW is the sum of Marginal Propensity to Save, Marginal Propensity to Import and Marginal Propensity to Tax.

Example 1:

The government has calculated the Marginal Propensity to Consume as 0.5. The government wants to know how much it needs to spend to close a recessionary gap of $400m.

Firstly we can calculate the multiplier:

1/(1-MPC) = 1/(1-0.5) = 1/0.5 = Multiplier Equals: 2.

Now we know the multiplier, we can now calculate how much the government needs to spend (autonomous spending) in order to close the recessionary gap.

$400m/2 = $200m. Autonomous Spending will multiply into $200m Induced Spending

Example 2:

The government has calculated the Marginal Propensity to Consume as 0.3. The government wants to know how much it needs to spend to close a recessionary gap of $500m.

Firstly we can calculate the multiplier:

1/(1-MPC) = 1/(1-0.3) = 1/0.7 = Multiplier Equals: 1.42

Now we know the multiplier, we can now calculate how much the government needs to spend (autonomous spending) in order to close the recessionary gap.

$500m/1.42 = $352m. Autonomous Spending will multiply into $147m Induced Spending

Example 3:

The government has calculated the following and wants to know how much they need to spend to close a recessionary gap of $700m

Marginal Propensity to Tax = 0.2

Marginal Propensity to Import = 0.1

Marginal Propensity to Save = 0.1

Firstly we can calculate the multiplier:

1/(MPW) = 1/(0.1+0.3+0.2) = 1/0.4 = Multiplier Equals: 2.5

Now we know the multiplier, we can now calculate how much the government needs to spend (autonomous spending) in order to close the recessionary gap.

$700m/2.5 = $280m. Autonomous Spending will multiply into $420m Induced Spending

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