Download LECTURE 6. Fiscal policy

Fiscal Policy
Fiscal Policy is a system of goals, tools and instruments to affect GDP and
employment.
The Subject of the fiscal policy is the Ministry of Finance (the Treasury in the
U.S.)
The goals of fiscal policy that we will study in this course are related to the
cyclical fluctuations in the economy.
Types of fiscal policy
1. Demand side fiscal policy (Keynesian fiscal policy)
If the economy is depressed and AD < Y, the government might use fiscal policy
to encourage an increase in the aggregate demand. The difference between the potential
GDP and the actual GDP is called a recessionary gap.
If the AD is expanding too fast and increases above the potential GDP, it might
generate high inflationary pressures. Then, the government can apply fiscal policy to
discourage the overheating of the economy.
The difference between actual GDP and the potential GDP is called an
inflationary gap.
From this perspective, we distinguish between expansionary and restrictive fiscal
policy. The expansionary fiscal policy would reduce the recessionary gap, while the
restrictive fiscal policy will reduce the inflationary gap.
1.1. Tools and instruments of fiscal policy
The Ministry of Finance can affect GDP and employment through government revenues
and government spending. These are the major tools of fiscal policy.
They are recorded in the government budget.
 Government revenues
 Government spending – government purchases and transfer payments
1.1.1.Government budget
The government budget is an assessment of government revenues and
expenditures,
deficits and surpluses of government finance
The Government Budget
expenditures
revenues
G
Transfer payments
Taxes
The government can use government spending, or government revenues to affect
the economic activity.
a) Affecting GDP through G
Expansionary policy:
Government spending is an injection. Therefore, if the government wishes to
encourage the economic activity, because AD < Y, it can increase G. Aggregate
demand will rise and the multiplier process will be put into action.
Unemployment will fall.
Restrictive policy:
If the government wants to reduce the overspending in the economy, because
AD>Y, it can reduce G. Aggregate demand will fall and again the multiplier process
will be put into action.
Unemployment will increase.
b) Affecting GDP through taxes
A second way to affect the economic activity is through manipulations with taxation.
Taxes are a leakage.
Expansionary policy:
If the government wants to encourage economic activity, it can reduce taxes.
Aggregate demand will increase and the multiplier process will be put into action.
Restrictive policy:
If the government wants to restrict economic activity, it can raise taxes. Aggregate
demand will fall and the multiplier process will be put into action.
c) GDP Gaps
The anticyclical fiscal policy aims to reduce aggregate demand fluctuations.
During the recession, when aggregate demand declines, the equilibrium GDP fall below
the potential GDP. The difference between the potential GDP and the actual GDP is
called the recessionary gap of GDP (fig. 1 on the left).
When aggregate demand rises and goes above the potential GDP, it opens an
inflationary gap of GDP (fig. 1 on the right).
GDP gaps
Price level
Price level
AD
AS
AD
AS
Y1
Y*
Y* - Y1 = recessionary gap
GDP
GDP
Y* Y2
Y2 – Y* = inflationary gap
Fig. 1. GDP gaps
The expansionary fiscal policy enforced during the recession aims to reduce the
recessionary gap.
The restrictive fiscal policy enforced during the boom aims to reduce the inflationary
gap.
1.2. Effectiveness of fiscal policy
The impact of the manipulations with G and T on the economy is not equal. Since
G is a component of aggregate expenditures, the increase in G by €1 million, means
and increase in AD by €1 million.
If, however, taxes are reduced by €1 million, the disposable income will increase by
€1 million, but households will not spend all this money. They will save part of it.
Therefore, they will spend less than €1 million. Aggregate demand will increase by
less. The impact of the change in taxes on the economic activity, therefore, depends
on the marginal propensity to consume and the marginal propensity to save.
1.2.1. Taxation multiplier
The taxation multiplier indicates by how much in will GDP increase as a result of
a change in the tax rate.
Taxation multiplier = - MPC/MPS
The taxation multiplier is always negative, because tax reductions lead to GDP
increase, and tax increase leads to GDP reduction.
Conclusion: changes in G are more effective as an instrument of fiscal policy than
changes in taxes, because the latter have an indirect impact on aggregate demand
(through the disposable income).
1.2.2.Budget deficit (surplus)
If government expenditures are greater than taxes, there is a budget deficit.
If taxes are greater than government spending, there is a surplus.
If there is a budget deficit, the government will borrow money in order to pay for
everything that it has to.
As opposed to the firms, the government cannot go
bankrupt. This is why it’s demand for funds (money) is highly inelastic. Moreover,
usually the government needs a lot amount of money. When it goes to the financial
markets to borrow money, the demand in these markets increases and the interest rate
on loans rises.
The higher interest rate demotivates businesses to invest in investment projects,
which would give lower profitability.
Therefore, private investment is crowded out from the economy.
The crowding out effect occurs because the government borrows money in the
financial markets and the interest rate increases.
Budget deficit (surplus):
 Primary deficit (surplus) = current revenues-current expenditures
 Secondary deficit (surplus) = primary deficit (surplus) + interest payments on
domestic debt
 Cash deficit (surplus) = secondary deficit (surplus) + flows of external revenues
and payments
Government debt is the accumulated deficit.
1.3.Built-in stabilizers
The development and the enforcement of fiscal policy involves time lags. The
policy could be enforced much later than when it was needed. However, there are
such mechanisms and rules in the government budget and in the economy, which
automatically will work anticyclically.
When the economy is slowing down, these rules will automatically lead to an
increase in government spending and a reduction in taxes.
When the economy is overheated, they will automatically lead to a reduction in
government spending and an increase in taxes.
These are automatic stabilizers.
In the budget these are: income taxes, corporate taxes, social payments. When the
economy is depressed and income falls, income taxes fall too, corporate profits and
taxes fall too. Unemployment rises and social payments increase. When the economy
is in a boom, it is the other way round.
2. Supply-side fiscal policy
This is a system of goals, tools and instruments to affect aggregate supply
2.1. Goals of the supply-side policy:
 Increase in productivity
 Reduction of the inflationary pressure
 Reduction in the need for government spending
 Reduction of government debt
 Reduction of the crowding-out effect
2.2. Tools of the supply-side policy:

Changes in the tax rates.
Philosophy: The increase in taxes reduces the enthusiasm of people to work and
invest. If taxes fall, people will be willing to work more and firms will be willing to
invest more. Therefore, tax reductions motivate the supply side of the economy and
increase the potential GDP.
.2.3. Effectiveness of the supply side-policy:
It depends on the elasticity of labor supply and capital supply as regard payments
for labor and capital. If labor and capital are sensitive to changes in their rewards, they
will increase supply with the reduction in income taxes and the increase in disposable
income. Such sensitivity was demonstrated by American, British and Irish capital and
labor owners. For example, when the American government reduced income taxes,
American workers realized that they will have much more money if they work more, and
the government will not get more taxes of the extra income. Thus, they were willing to
work more. Tax reductions affected the willingness of capital owners to supply more
capital in the same way. As a result, both output and productivity in the US economy
increased. When French government reduced taxes, French workers realized that they
could have the same income as before, if they were working less. They preferred leisure
to higher income. Thus, labor supply in France was not elastic as regard disposable
income. As a result, output and productivity in France did not increase.
2.4 The Laffer curve
Т
t
0
100%
Fig.1. The Laffer curve
The Laffer Curve shows that from a particular point, the further increase in tax
rates starts reducing tax revenues of the government.