Fiscal policy

Fiscal Policy

PREPARED BY:

UMAIR

Introduction

Fiscal policy uses government purchases, transfer payments, taxes, and borrowing to affect macroeconomic variables such as employment, the price level, and the level of GDP.

Expansionary Fiscal PolicyWhen the economy is in recession,

government wants to increase AD Tax cut: increases consumers disposable

incomeIncreases AD as long as consumers don’t

increase savings or spending on imports Increase in government spending:

directly shifts the AD curve

Contractionary Fiscal Policy

When economy is suffering from inflation, government wants to decrease AD

Tax increase: decreases disposable income of consumers

AD curve shifts left, both inflation and GDP decrease

Decrease in government spending: directly shifts the AD curve left

Tools of Fiscal Policy

1. Automatic Stabilizers

Structural features of government spending and taxation that smooth fluctuations in disposable income, and hence consumption, over the business cycle.

Automatic Stabilizers

There are several fiscal programs that provide countercyclical policy and take effect automatically, without a change in legislation.

Automatic Stabilizers1. Unemployment compensation When economy is in recession, people are laid off. Unemployment compensation spending goes up (G increases) to

pay unemployed workers and Unemployment compensation taxes imposed on businesses will decrease because of the reduction in employment.

Government spend goes up, Government Tax Receipts go down, pushing the budget toward a deficit during a recession, supplying the expansionary fiscal policy at the right time.

During an expansion, Unemployment compensation payments go down, Unemployment compensation taxes go up.

Government spending fall, government receipts rise, so the budget moves toward a surplus (restrictive fiscal policy) at the right time.


2. Corporate Profit Tax ReceiptsCorporate profit tax receipts are highly

sensitive to economic conditions and thus highly cyclical, going up during an expansion and falling during a recession.

By going down during a recession, falling corporate taxes help move the budget toward a deficit during a contraction.


3. Progressive Income Tax SystemProgressive income tax system provides auto

stabilizer. When incomes are rising, economy is expanding,

people get forced into higher tax brackets, raising income tax receipts, moving the budget toward a surplus.

When incomes are falling, people move to lower tax brackets, reducing income tax receipts and moving the economy toward a deficit.


Conclusion, during a recession, budget automatically moves toward a deficit, due to: increased unemployment payments, decreased unemployment taxes, corporate taxes and personal income taxes.

During an expansion, budgets automatically moves toward surplus due to: reduced unemployment payments, increased unemployment taxes, corporate taxes and personal taxes.

Tools of Fiscal Policy

2. Discretionary Fiscal Policy The deliberate manipulation of

government purchases, taxation, and transfers in order to promote macroeconomic goals such as full employment, price stability, and economic growth.

Discretionary Fiscal Policy

1. Changes in Government PurchasesCan increase spending in normal budgetary

programs (health, education, welfare, etc.) Can increase spending on infrastructure

(underlying economic foundation of goods and services that allows a society to function e.g. build roads, schools, communication systems)

Added advantage of increasing capital goods in economy which can shift AS in the future


2. Changes in Net TaxesDecrease in net taxes increases

disposable income consumption increases increases real GDP demanded.

Increase in net taxes decreases disposable income consumption decreases decreases real GDP demanded.


Discretionary Fiscal Policy in Response to a Contractionary Gap

Suppose that in short-run equilibrium, we have a contractionary gap.

Unemployment is above the natural rate. If the market adjusts naturally, the nominal price of resources

will drop in the long run; short-run aggregate supply would shift out to achieve equilibrium at potential output.

Often, however, wages and prices are slow to adjust. Government may introduce fiscal policy to move the economy

more quickly back to potential output. They might change net taxes or government spending or both.

Discretionary Fiscal PolicyDiscretionary Fiscal Policy in Response to an

Expansionary GapIf short-run equilibrium price level exceeds the

level on which long-term contracts were based, output exceeds potential GDP.

In the long run, we expect the short-run aggregate supply curve to shift back, returning the economy to potential output and increasing the price level.

Use of discretionary fiscal policy can avoid inflation.

Fiscal Policy and the Multiplier

Fiscal policy has a multiplier effect on the economy. Expansionary fiscal policy leads to an increase in real GDP

larger than the initial rise in aggregate spending caused by the policy.

The government spends an additional $4 Billion through discretionary fiscal policy.

The total effect on GDP will be larger than $4 Billion. The multiplier effect refers to the additional shifts in aggregate

demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Conversely, contractionary fiscal policy leads to a fall in real GDP larger than the initial reduction in aggregate spending caused by the policy.

The Budget BalanceOther things equal, discretionary expansionary fiscal

policies—increased government purchases of goods and services, higher government transfers, or lower taxes—reduce the budget balance for that year.

That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger.

Conversely, contractionary fiscal policies—smaller government purchases of goods and services, smaller government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

Government Budgets

Deficit budget: government spends more than it receives in tax revenue (must borrow money to cover shortfall)

Surplus budget: government collects more in taxes than it spends Balanced budget: government spends amount equal to collected tax

revenue Debt: total amount owed by the government Deficits Versus Debt A deficit is the difference between the amount of money a government

spends and the amount it receives in taxes over a given period. A debt is the sum of money a government owes at a particular point in

time. Deficits and debt are linked, because government debt grows when

governments run deficits. But they aren’t the same thing, and they can even tell different stories.

Should the Budget Be Balanced?

Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.

Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.

Problems Posed by Rising Government DebtPublic debt may crowd out investment

spending, which reduces long-run economic growth.

And in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil.

Can’t a government that has trouble borrowing just print money to pay its bills?

Yes, it can, but this leads to another problem: inflation.

Drawbacks and Limitations of Fiscal PolicyTime lags are significantRecognition lag: time it takes government

to recognize there is a problemDecision lag: time required for government

to determine most appropriate policyImplementation lag: time it takes to figure

out how to implement new directivesImpact lag: time it takes to be felt through

multiplier effect

Drawbacks and Limitations of Fiscal PolicyDifficulties in changing spending and taxation

policiesIt is far easier to increase spending and decrease

taxes then to increase taxes and decrease spending

Conflict between levels of government over appropriate policies. Federal, provincial and city governments may differ on what needs to be done.

Regional variations: Some provinces can be in recession while others are still growing.

Drawbacks and Limitations of Fiscal PolicyCrowding Out

Scenario I Economy is in recession. Government runs budget deficit to stimulate the economy back to

full output. Deficit requires borrowing. Government borrowing puts upward pressure on interest rates. Government competes for limited funds with businesses. At higher interest rates, private investment gets "crowded out.“ Less private investment at higher interest rates, so AD may not

shift all the back to full employment output. Also, less private investment has negative effect on output in

future periods due to lower supply of capital equipment.

Drawbacks and Limitations of Fiscal PolicyScenario II Economy is expanding.Government decreases spending and/or raises

taxes and runs smaller budget deficit.Reduces demand for credit, putting downward

pressure on interest rates. Lower interest rates stimulate the economy and

may prevent the economy from returning to full output - economy will stay above full output.

Drawbacks and Limitations of Fiscal PolicyFeedback Effects of Fiscal Policy on Aggregate

SupplyFiscal policy may affect aggregate supply, often

unintentionally.Changes in transfer payments/taxes not only affect

AD, but could cause changes in the labor supply. Both automatic stabilizers, unemployment insurance

and the progressive income tax, and discretionary fiscal policy, such as changes in tax rates, may affect individual incentives to work, spend, save, and invest, although these effects are usually unintended.

Drawbacks and Limitations of Fiscal PolicyDiscretionary Policy and Permanent IncomePermanent Income – Income individuals expect to

receive on average over the long term.People base their consumption decisions not just

on current income but also on permanent income.If people view tax changes as only temporary, they

will not have their desired effect.To the extent that consumers base spending

decisions on their permanent income, attempts to fine-tune the economy with tax-rate adjustments thought to be temporary will be less effective.

The Evolution of Fiscal Policy

Prior to the Great Depression, public policy was based on the views of classical economists.

The object of fiscal policy was only to balance the budget.


Classical economists – A group of 18th- and 19th- century economists who believed that recessions were short-run phenomena that corrected themselves through natural market forces; thus they believed the economy was self-correcting.

They believed that most economic crises were caused by sources other than market forces (wars, poor growing seasons, and changes in tastes.)

They felt that active fiscal policy would do more harm than good.

Recessions/inflation temporary and would be fixed by market forces.


Great Depression and WWII

3 things happened to increase the use of discretionary fiscal policy

1. 1936 Keynes' The General Theory

Keynesian theory and policy were developed to address the

problem of unemployment arising from the Great Depression.

He argued that prices, wages were not flexible enough to ensure full employment of resources.

Business expectations might at times be so grim, that even high low rates wouldn’t get firms investing.


2. WWII increased production and eliminated cyclical unemployment during the war years, pulling the economy out of the depression.

3. Employment Act of 1946 gave the federal government the responsibility for promoting full employment and price stability.


MODERN VIEW OF FISCAL POLICY(Accepted by most Keynesian and non-Keynesians)1. When substantial unused capacity is present during a recession, expansionary fiscal policy may be able to help stimulate the economy back to full employment.

2. During normal economy times, fiscal policy is relatively ineffective at stimulating AD, due to the secondary effects of crowding out, exports declining and/or people saving tax cuts.

3. Proper timing of discretionary policy is both extremely difficult to achieve and extremely crucial if it is to help the econ. Because of this, most economy favor active, discretionary fiscal policy only in response to a major recession.

Economy & Finance

Fiscal policy