Fiscal Policy Effects

7/31/2019 Fiscal Policy Effects

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Fiscal Policy Effects

Fiscal policy decisions have a widespread effect on the everyday decisions andbehaviour of individual households and businesses hence in this note we considersome of the microeconomic effects of fiscal policy before considering the links

between fiscal policy and aggregate demand and key macroeconomic objectives.

The microeconomic effects of fiscal policy

1. Taxation and work incentivesCan changes in income taxes affect the incentive to work? This remains acontroversial subject in the economic literature!

Consider the impact of an increase in the basic rate of income tax or an increase inthe rate of national insurance contributions. The rise in direct tax has the effect of

reducing the post-tax income of those in work because for each hour of work takenthe total net income is now lower. This might encourage the individual to work morehours to maintain his/her target income. Conversely, the effect might be toencourage less work since the higher tax might act as a disincentive to work. Ofcourse many workers have little flexibility in the hours that they work. They will becontracted to work a certain number of hours, and changes in direct tax rates will notalter that.

The government has introduced a lower starting rate of income tax for lower incomeearners. This is designed to provide an incentive for people to work extra hours andkeep more of what they earn.

Changes to the tax and benefit system also seek to reduce the risk of the povertytrap where households on low incomes see little net financial benefit fromsupplying extra hours of their labour. If tax and benefit reforms can improveincentives and lead to an increase in the labour supply, this will help to reduce theequilibrium rate of unemployment (the NAIRU) and thereby increase the economysnon-inflationary growth rate.

2. Taxation and the Pattern of Demand


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Changes to indirect taxes in particular can have an effect on the pattern ofdemand for goods and services. For example, the rising value of duty on cigarettesand alcohol is designed to cause a substitution effect among consumers and therebyreduce the demand for what are perceived as de-merit goods. In contrast, agovernment financial subsidy to producers has the effect of reducing their costs ofproduction, lowering the market price and encouraging an expansion of demand.

The use of indirect taxation and subsidies is often justified on the grounds ofinstances ofmarket failure. But there might also be a justification based on achievinga more equitable allocation of resources e.g. providing basic state health care freeat the point of use.

3. Taxation and labour productivitySome economists argue that taxes can have a significant effect on the intensity withwhich people work and their overall efficiency and productivity. But there is littlesubstantive empirical evidence to support this view. Many factors contribute toimproving productivity tax changes can play a role - but isolating the impact of taxcuts on productivity is extremely difficult.


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4. Taxation and business investment decisionsLower rates of corporation tax and other business taxes can stimulate an increase inbusiness fixed capital investment spending. If planned investment increases, thenations capital stock can rise and the capital stock per worker employed can rise.

The government might also use tax allowances to stimulate increases in research anddevelopment and encourage more business start-ups. A favourable tax regime couldalso be attractive to inflows of foreign direct investment a stimulus to the economythat might benefit both aggregate demand and supply. The Irish economy is oftentouted as an example of how substantial cuts in the rate of corporation tax can act asa magnet for large amounts of inward investment. The very low rates of company taxhave been influential although it is not the only factor that has underpinned thesensational rates of economic growth enjoyed by the Irish economy over the lastfifteen years.

Capital investment should not be seen solely in terms of the purchase of newmachines. Changes to the tax system and specific areas of government spending mightalso be used to stimulate investment in technology, innovation, the skills of thelabour force and social infrastructure. A good example of this might be a substantialincrease in real spending on the transport infrastructure. Improvements in ourtransport system would add directly to aggregate demand, but would also provide aboost to productivity and competitiveness. Similarly increases in capital spending ineducation would have feedback effects in the long term on the supply-side of theeconomy.

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demandmanagement. This means that changes in spending and taxation can beused counter-cyclically to help smooth out some of the volatility of real nationaloutput particularly when the economy has experienced an external shock.

Discretionary changes in fiscal policy and automatic stabilisers

Discretionary fiscal changes are deliberate changes in direct and indirect taxationand govt spending for example a decision by the government to increase totalcapital spending on the road building budget or increase the allocation of resources

going direct into the NHS.

Automatic fiscal changes are changes in tax revenues and government spendingarising automatically as the economy moves through different stages of the businesscycle. These changes are also known as theautomatic stabilisers of fiscal policy

Tax revenues: When the economy is expanding rapidly the amount of taxrevenue increases which takes money out of the circular flow of income and


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spending Welfare spending: A growing economy means that the government does not

have to spend as much on means-tested welfare benefits such as incomesupport and unemployment benefits

Budget balance and the circular flow: A fast-growing economy tends to leadto a net outflow of money from the circular flow. Conversely during aslowdown or a recession, the government normally ends up running a largerbudget deficit.

Estimates from economists at the OECD have found that the effects of the automaticstabilisers of fiscal policy can reduce the volatility of the economic cycle by up to20%. In other words, if the government is prepared to allow the automatic stabilisersto work through fully, the fiscal policy can help to curb the excessive growth ofdemand during a boom, but also provide an important support for income and demandduring an economic downturn.

Measuring the fiscal stance

The fiscal stance is a term that is used to describe whether fiscal policy is being usedto actively expand demand and output in the economy (a reflationary or expansionary


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fiscal stance) or conversely to take demand out of the circular flow (a deflationaryfiscal stance).

A neutral fiscal stance might be shown if the government runs with a balancedbudget where government spending is equal to tax revenues. Adjusting for where the

economy is in the economic cycle, a neutral fiscal stance means that policy has noimpact on the level of economic activityA reflationary fiscal stance happens when the government is running a large deficitbudget (i.e. G>T). Loosening the fiscal stance means the government borrows moneyto inject funds into the economy so as to increase the level of aggregate demand andeconomic activity.A deflationary fiscal stance happens when the government runs a budget surplus (i.e.G


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Monetarist economists on the other handbelieve that government spending and taxchanges can only have a temporary effect on aggregate demand, output and jobs andthat monetary policy is a more effective instrument for controlling demand andinflationary pressure. They are much more sceptical about the wisdom of relying onfiscal policy as a means of demand management. We will consider below some of thecriticisms of using fiscal policy as a tool of stabilising demand and output in theeconomy.

The multiplier effects of an expansionary fiscal policy depend on how much spareproductive capacity the economy has; how much of any increase in disposable incomeis spent rather than saved or spent on imports. And also the effects of fiscal policy onvariables such as interest rates


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Problems with Fiscal Policy as an Instrument of Demand Management

In theory a positive or negative output gap can be relatively easily overcome by thefine-tuning of fiscal policy. However, in reality the situation is complex and manyeconomists argue for ignoring fiscal policy as a tool for managing aggregate demandfocusing instead on the role that monetary policy can play in stabilising demand andoutput.

Recognition lags and policy time lags

o Inevitably, it takes time to for government policy-makers to recognise that ADis growing either too quickly or too slowly and a need for some activediscretionary changes in spending or taxation

o It then takes time to implement an appropriate policy response governmentspending plans are subject to a three year spending review and cannot bechanged immediately. Likewise the tax system is highly complex for example income tax can only normally be changed once a year at the time of theBudget. Indirect taxes can be changed more quickly but they have less of aneffect on the level of aggregate demand

o It then takes time for the change in fiscal policy to work, as the multiplier


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process on national income, output and employment is not instantaneous.

The importance of the national income multiplier imperfect information

Suppose a government wanted to eliminate a deflationary gap of 1000m. The

increase needed in government expenditure will depend on the size of the multiplier.The problem lies in knowing the exact size of the multiplier. If the multiplier is 2,then government expenditure would have to rise by 500m. However, if the multiplierwas 4, a rise of only 250m would be needed. Without knowing the precise value ofthe national income multiplier it is difficult to fine-tune the economy accurately.

Fiscal Crowding-Out

The crowding-out hypothesis became popular in the 1970s and 1980s when freemarket economists argued against the rising share of national income being taken bythe public sector. The essence of the crowding out view is that a rapid growth of

government spending leads to a transfer of scarce productive resources from theprivate sector to the public sector. For example, if the government seeks to reflateAD by reducing taxation, or by increasing government spending, then this may lead toa budget deficit. To finance the deficit the government will have to sell debt to theprivate sector. Attracting individuals and institutions to purchase the debt mayrequire higher interest rates. A rise in interest rates may crowd out privateinvestment and consumption, offsetting the fiscal stimulus.

This type of crowding out is unlikely to make fiscal policy wholly ineffective butlarge budget deficits do require financing and in the long run, this requires a higherburden of taxation. Higher taxes affect both businesses and households neo-liberal

economists believe that higher taxation acts as a drag on business investment, labourmarket incentives and productivity growth all of which can have a negative effect oneconomic growth potential in the long run.


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The Keynesian response to the crowding-out hypothesis is that the probability of 100%crowding-out is extremely remote, especially if the economy is operating well belowits productive capacity and if there is a plentiful supply of savings available that thegovernment can tap into when it needs to borrow money. There is no automaticrelationship between the level of government borrowing and the level of short termand long term interest rates. We can see from the previous chart that there has beena downward trend in long term interest rates over the last tent to twelve years.Indeed in 2003 the yield (rate of interest) on ten year government bonds dippedbelow 4 per cent one of the lowest long term interest rates in recent history.

Reaction to Tax Cuts Rational Expectations

According to a school of economic thought that believes in rational expectations,when the government sells debt to fund a tax cut or an increase in expenditure, thena rational individual will realise that at some future date he will face higher taxliabilities to pay for the interest repayments. Thus, he should increase his savings asthere has been no increase in his permanent income. The implications are clear. Anychange in fiscal policy will have no impact on the economy if all individuals arerational. Fiscal policy in these circumstances may become impotent.Partly because of the limitations of fiscal policy as a tool of demand management,


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many governments have switched the focus of fiscal policy towards using it to improveaggregate supply as a means of creating the conditions for sustainable economicgrowth. This is certainly the case with the current government.

Government borrowing

The level of government borrowing is an important part offiscal policy andmanagement of aggregate demand in any economy. When the government is runninga budget deficit, it means that in a given year, total government expenditure exceedstotal tax revenue. As a result, the government has to borrow through the issue ofdebt such as Treasury Bills and long-term government Bonds. The issue of debt is doneby the central bank and involves selling debt to the bond and bill markets.

Recent trends in UK government borrowing

Government finances have moved from surplus in the late 1990s to a deficit of over2.5 % of GDP in 2003-04. The emergence of a rising budget deficit has been due to aweaker economy and the effects of substantial increases in government spending onpriority areas such as health, education, transport and defence. Both current and


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capital spending are rising sharply in real terms. Critics of Gordon Brown argue thathe risks losing control of the budget deficit if tax revenues continue to come in belowforecast whilst public sector spending remains high. Gordon Browns reputation offiscal prudence has come under pressure both before and after the most recentelection.

Does a budget deficit matter?

There is a consensus that a persistently large budget deficit can be a problem for thegovernment and the economy. Three of the reasons for this are as follows:

Financing a deficit: A budget deficit has to be financed and day-today, theissue of new government debt to domestic or overseas investors can do this. Ina world where financial capital flows freely between countries, it can berelatively easy to finance a deficit. But it may be that if the budget deficitrises to a high level, in the medium term the government may have to offer

higher interest rates to attract sufficient buyers of government debt. This inturn will have a negative effect on economic growth A government debt mountain? In the long run, government borrowing adds to

the accumulatedNational Debt. This means that the Government has to spendmore each year in debt-interest payments to holders of government bonds andother securities. There is an opportunity cost involved here because thismoney might be used in more productive ways, for example an increase inspending on health services or extra investment in education. It also representsa transfer of income from people and businesses that pay taxes to those whohold government debt and cause a redistribution of income and wealth in theeconomy

Crowding-out - the need for higher interest rates and highertaxes. Eventually the budget deficit has to be reduced. This can be achievedby either by cutting back on public sector spending or by raising the burden oftaxation. If a larger budget deficit leads to higher interest rates and taxation inthe medium term and thereby has a negative effect on growth in consumptionand investment spending, then a process of fiscal crowding-out is said to beoccurring.

Wasteful public spending: Neo-liberal economists are naturally opposed to ahigh level of government spending. They believe that a rising share of GDPtaken by the state sector has a negative effect on the growth of the privatesector of the economy. They are sceptical about the benefits of higher

spending believing that the scale of waste in the public sector is high moneythat would be better off being used by the private sector.


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Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of governmentspending and borrowing? Two main arguments stand out

1. Government borrowing can benefit economic growth: A budget deficit canhave positive macroeconomic effects in the long run if it is used to financeextra capital spending that leads to an increase in the stock of national assets.For example, spending on the transport infrastructure improves the supply-side capacity of the economy. And increased investment in health andeducation can bring positive effects on productivity and employment.

2. The budget deficit as a tool of demand management: Keynesian economistswould support the use of changing the level of government borrowing as alegitimate instrument of managing aggregate demand. An increase in borrowingcan be a useful stimulus to demand when other sectors of the economy aresuffering from weak or falling spending. The fiscal stimulus given to the Britisheconomy during 2002-2004 has been important in stabilizing demand andoutput at a time of global economic uncertainty. Perhaps Keynesian fiscaldemand management has once more come back into fashion! The argument isthat the government can and should use fiscal policy to keep real national


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output closer to potential GDP so that we avoid a large negative output gap.

The current situation

Government borrowing in the UK has shot up to 3.4 percent of GDP in the lastfiscal year, in excess of the 3.0 percent limit set by Europe's Stability andGrowth Pact. But as the UK is not participating in the single currency, the UK isnot bound by the terms of the fiscal stability pact and this gives it moreflexibility in terms of how much the UK government can borrow

The government has allowed the automatic stabilisers to work during thecurrent cycle. In other words, it has allowed an increase in governmentborrowing brought about by a slowdown in domestic demand and output.

Gordon Brown has introduced his own fiscal rules including the goldenrule that government spending on currently provided goods and services shouldbe financed by taxation over the course of the economic cycle. Governmentcapital spending (public sector investment) can be financed by borrowing

because it results in the accumulation of capital which has long term economicbenefits for the country

Although government borrowing is currently high, there is little upwardpressure on long-term interest rates (indeed they are low). Financing thebudget deficit is not a major problem for the UK as it seems able to attractinflows of financial capital from overseas and foreign investors are happy topurchase new issues of government debt. This reduces the risk of the crowdingout effect taking place

Total government debt as a percentage of GDP remains low by historicalstandards (less than 40% of GDP). And with interest rates remaining low, the

government is not facing up to a huge cost of servicing this debt It is difficult to forecast government borrowing with great accuracy. Firstly this

is because government tax revenue and spending is sensitive to changes in theeconomic cycle. Secondly, we are dealing with huge numbers! Totalgovernment spending in 2003-04 is forecast to be 459 billion and total taxreceipts 422 billion (giving a forecast budget deficit of 37 billion). It onlytakes government spending and tax revenues to be 1% or 2% different fromcurrent forecasts for the budget deficit to change significantly

Inter-relationships between Fiscal & Monetary Policy

Fiscal policy should not be seen is isolation from monetary policy.

For most of the last thirty years, the operation of fiscal and monetary policy was inthe hands of just one person the Chancellor of the Exchequer. However the degreeof coordination the two policies often left a lot to be desired. Even though the BoEhas independence that allows it to set interest rates, the decisions of the MPC aretaken in full knowledge of the Governments fiscal policy stance. Indeed the Treasuryhas a non-voting representative at MPC meetings. The government lets the MPC know


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of fiscal policy decisions that will appear in the budget.

Impact of fiscal policy on the composition of output

Monetary policy is often seen as something of a blunt policy instrument affecting

all sectors of the economy although in different ways and with a variable impact.Fiscal policy changes can to a degree be targeted to affect certain groups (e.g.increases in means-tested benefits for low income households, reductions in the rateof corporation tax for small-medium sized enterprises and more generous investmentallowances for businesses in certain regions)

Consider the effects of using either monetary or fiscal policy to achieve a givenincrease in national income because actual GDP lies below potential GDP (i.e. there isa negative output gap)

o Monetary policy expansion: Lower interest rates will (ceteris paribus) lead toan increase in both consumer and business capital spending both of whichincreases equilibrium national income. Since investment spending results in alarger capital stock, then incomes in the future will also be higher through theimpact on LRAS.

o Fiscal policy expansion: An expansionary fiscal policy (i.e. an increase ingovernment spending or lower taxes) adds directly to AD but if this is financedby higher borrowing, this may result in higher interest rates and lowerinvestment. The net result (by adjusting the increase in G) is the same increasein current income. However, since investment spending is lower, the capitalstock is lower than it would have been, so that future incomes are lower.

Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession, monetary policy may be ineffective in increasingspending and income. In this case, fiscal policy might be more effective in stimulatingdemand. Other economists disagree they argue that changes in monetary policy canimpact quite quickly and strongly on consumer and business behaviour.

However, there may be factors which make fiscal policy ineffective aside from theusual crowding out phenomena. Future-oriented consumption theories based roundthe concept of rational expectations hold that individuals undo government fiscalpolicy through changes in their own behaviour for example, if government spending

and borrowing rises, people may expect an increase in the tax burden in future years,and therefore increase their current savings in anticipation of this

Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect the timelags are variable


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Monetary policy in the UK is flexible since interest rates can be changed by the Bankof England each month and emergency rate changes can be made in betweenmeetings of the MPC, whereas changes in taxation take longer to organize andimplement.

Because capital investment requires planning for the future, it may take some timebefore decreases in interest rates are translated into increased investment spending.Typically it takes six months twelve months or more before the effects of changes inUK monetary policy are felt. The impact of increased government spending is felt assoon as the spending takes place and cuts in direct and indirect taxation feed throughinto the economy pretty quickly. However, considerable time may pass between thedecision to adopt a government spending programme and its implementation. Inrecent years, the government has undershot on its planned spending, partly becauseof problems in attracting sufficient extra staff into key public services such astransport, education and health.

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Fiscal Policy Effects