Download 2.4 Fiscal Policy 2.3 Macroeconomic Objectives (Phillips Curve)

IB ECONOMICS
2.4 FISCAL POLICY
1. 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)
An indirect tax (such as sales tax, a specific tax, value
added tax (VAT), or goods and services tax (GST)) is a tax
collected by an intermediary (such as a retail store) from
the person who bears the ultimate economic burden of the
tax (such as the consumer). The intermediary later files a
tax return and forwards the tax proceeds to government
with the return.
In this sense, the term indirect tax is contrasted with a direct
tax which is collected directly by government from the
persons (legal or natural) on which it is imposed. Some
commentators have argued that
"a direct tax is one that cannot be shifted by the taxpayer to
someone else, whereas an indirect tax can be."
2. Explain that government spending can be classified into current
expenditures, capital expenditures and transfer payments, providing
examples of each.
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An operating expenditure, current expenditures or OPEX is
an ongoing cost for running a product, business, or system.
Capital expenditures or CAPEX are expenditures
creating future benefits. A capital expenditure is incurred
when a business/government spends money either to buy
fixed assets or to add to the value of an existing fixed
asset with a useful life extending beyond the taxable
year.
For example, the purchase of a photocopier involves
CAPEX, and the annual paper, toner, power and
maintenance costs represents OPEX.
2. Explain that government spending can be classified into current
expenditures, capital expenditures and transfer payments, providing
examples of each.
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A transfer payment (or government transfer or
simply transfer) is a redistribution of income in the
market system. These payments are considered to be
exhaustive because they do not directly absorb
resources or create output. In other words, the
transfer is made without any exchange of goods or
services.
Examples of certain transfer payments include
welfare (financial aid), social security, and
government making subsidies for certain businesses
(firms).
3. Distinguish between a budget deficit, a budget surplus
and a balanced budget.
The Government budget balance, also commonly referred to
as general government balance, public budget balance, or
public fiscal balance, is the overall result of a country's
general government budget over the course of an accounting
period (usually one year).
It includes all government levels (from national to local) and
public social security funds.
The budget balance is the difference between government
revenues (e.g., tax) and spending.
A positive balance is called a government budget surplus.
A negative balance is called a government budget deficit.
Budget Puzzle: You Fix the Budget
4. Explain the relationship between budget deficits/ surpluses and the public
(government) debt.
The government budget balance is used to assess the fiscal
health of a country.
Keynesian economics advocates a government budget deficit
during recession or downturn as long as it is limited enough to
render the structural government budget balance positive.
The two basic elements of any budget are the revenues and
expenses. In the case of the government, revenues are derived
primarily from taxes.
Government expenses include spending on current goods and
services, which economists call government consumption;
government investment expenditures such as infrastructure
investment or research expenditure; and transfer payments
like unemployment or retirement benefits.
4. Explain the relationship between budget deficits/ surpluses and the public
(government) debt.
Government debt (also known as public debt,
national debt) is the debt owed by a central
government. (In the U.S. and other federal states,
"government debt" may also refer to the debt of a
state or provincial government, municipal or local
government.)
By contrast, the annual "government deficit" refers
to the difference between government receipts and
spending in a single year, that is, the increase of
debt over a particular year. (Govt Debt % GDP)
5.Explain how changes in the level of government expenditure
and/or taxes can influence the level of aggregate demand in an
economy.
Fiscal policy is the use of government revenue collection
(taxation) and expenditure (spending) to influence the
economy. The two main instruments of fiscal policy are
government taxation and expenditure. Changes in the
level and composition of taxation and government spending
can impact the following variables in the economy:
• Aggregate demand and the level of economic activity;
• The pattern of resource allocation;
• The distribution of income.
Fiscal policy refers to the use of the government budget to
influence economic activity.
5. Explain how changes in the level of government expenditure and/or
taxes can influence the level of aggregate demand in an economy.
Governments use fiscal policy to influence the level of aggregate
demand in the economy, in an effort to achieve economic objectives
of price stability, full employment, and economic growth.
Keynesian economics suggests that increasing government
spending and decreasing tax rates are the best ways to stimulate
aggregate demand, and decreasing spending & increasing taxes
after the economic boom begins.
Keynesians argue this method be used in times of recession or low
economic activity as an essential tool for building the framework for
strong economic growth and working towards full employment.
In theory, the resulting deficits would be paid for by an expanded
economy during the boom that would follow; this was the reasoning
behind the New Deal.
5. Explain how changes in the level of government expenditure and/or
taxes can influence the level of aggregate demand in an economy.
Governments can use a budget surplus to do two
things:
 to slow the pace of strong economic growth,
 and to stabilize prices when inflation is too high.
Keynesian theory predicts that removing spending
from the economy will reduce levels of aggregate
demand and contract the economy, thus stabilizing
prices.
6. Explain the mechanism through which expansionary fiscal policy
can help an economy close a deflationary (recessionary) gap.
Expansionary Fiscal Policy
Fiscal policy is said to be loose or expansionary when
government spending exceeds revenue. In these cases, the fiscal
budget is in deficit. While the absolute amount of deficit is
important, what is often more important is the change in the
deficit (or surplus).
Government action to cut taxes, increase transfer payments or
both, has the effect of raising households' disposable incomes
and promoting consumer spending.
Expansionary fiscal policy is used to address business-cycle
instability that gives rise to the problem of unemployment, that is,
to close a recessionary gap. This gap arises during a businesscycle contraction and typically gives rise to higher rates of
unemployment.
7. Construct a diagram to show the potential effects of expansionary fiscal policy,
outlining the importance of the shape of the aggregate supply curve.
7. Construct a diagram to show the potential effects of expansionary fiscal
policy, outlining the importance of the shape of the aggregate supply curve.
The flatter the SRAS curve the less will be price
pressure as AD increases. (Real GDP will be effected
more so) The steeper the SRAS curve the more price
pressure will increase as AD increase. (Less effect on
Real GDP)
The multiplier will have a larger effect on the
economy in the flatter portion of the SRAS curve and
the multiplier will have a small effect in the steeper
portion of the SRAS curve due to higher price levels.
8. Explain the mechanism through which contractionary fiscal
policy can help an economy close an inflationary gap.
Contractionary Fiscal Policy
Fiscal policy is said to be tight or contractionary when
government revenue exceeds spending.
In these cases, the fiscal budget is in surplus. While the absolute
amount of surplus is important, what is often more important is the
change in the surplus (or deficit).
Government action to raise taxes, reduce transfer payments or
both, has the effect of reducing households' disposable incomes
and depressing consumer spending.
Contractionary fiscal policy is designed to restrain the economy
during or anticipation of an inflation-inducing business-cycle
expansion.
9. Construct a diagram to show the potential effects of contractionary fiscal
policy, outlining the importance of the shape of the aggregate supply curve.
9. Construct a diagram to show the potential effects of contractionary fiscal
policy, outlining the importance of the shape of the aggregate supply curve.
The flatter the SRAS curve the less will be price
pressure as AD decreases . (Real GDP will be
effected more so) The `steeper the SRAS curve the
more price pressure will decrease as AD decrease.
(Less effect on Real GDP)
The multiplier will have a larger effect on the
economy in the flatter portion of the SRAS curve and
the multiplier will have a small effect in the steeper
portion of the SRAS curve due to higher price levels.
9. Construct a diagram to show the potential effects of contractionary fiscal
policy, outlining the importance of the shape of the aggregate supply curve.
9. Construct a diagram to show the potential effects of contractionary fiscal
policy, outlining the importance of the shape of the aggregate supply curve.
Fiscal Policy
9. Construct a diagram to show the potential effects of contractionary fiscal
policy, outlining the importance of the shape of the aggregate supply curve.
10. Explain how factors including the progressive tax system and unemployment
benefits, which are influenced by the level of economic activity and national income,
automatically help stabilize short-term fluctuations.
AUTOMATIC STABILIZERS:
Taxes and transfer payments that
depend on the level of aggregate
production and income such that
they automatically dampen
business-cycle instability without
the need for discretionary policy
action. Automatic stabilizers are
a form of nondiscretionary fiscal
policy that do not require explicit
action by the government sector to
address the ups and downs of the
business cycle and the problems
of unemployment and inflation.
10. Explain how factors including the progressive tax system and unemployment
benefits, which are influenced by the level of economic activity and national income,
automatically help stabilize short-term fluctuations.
Automatic stabilizers are a part of the structure
of the economy that work to limit the expansions
and contractions of the business cycle over what
they would be otherwise.
Induced taxes and transfer payments, payments
from and to the household sector to the
government sector, that are based on the level of
aggregate production and income are the source
of automatic business-cycle stabilization.
10. Explain how factors including the progressive tax system and unemployment
benefits, which are influenced by the level of economic activity and national income,
automatically help stabilize short-term fluctuations.
An increase in
aggregate production
and income associated
with a business-cycle
expansion causes an
increase in taxes and a
decrease in transfer
payments, both of
which limit the increase
in disposable income
and thus also limit the
expansion.
10. Explain how factors including the progressive tax system and unemployment
benefits, which are influenced by the level of economic activity and national income,
automatically help stabilize short-term fluctuations.
Alternatively, a
decrease in aggregate
production and income
associated with a
business-cycle
contraction causes a
decrease in taxes and
an increase in transfer
payments, both of which
limit the decrease in
disposable income and
thus also limit the
contraction.
10. Explain how factors including the progressive tax system and unemployment
benefits, which are influenced by the level of economic activity and national
income, automatically help stabilize short-term fluctuations.
Income taxes are generally at least somewhat progressive. This
means that as household incomes fall during a recession,
households pay lower rates on their incomes as income tax.
Therefore, income tax revenue tends to fall faster than the fall
in household income.
 Corporate tax is generally based on profits, rather than revenue.
In a recession profits tend to fall much faster than revenue.
Therefore, a company pays much less tax while having slightly
less economic activity.
 Sales tax depends on the dollar volume of sales, which tends to
fall during recessions.
Most governments also pay unemployment and welfare benefits.
Generally speaking, the number of unemployed people and those
on low incomes who are entitled to other benefits increases in a
recession and decreases in a boom.
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10. Explain how factors including the progressive tax system and unemployment
benefits, which are influenced by the level of economic activity and national income,
automatically help stabilize short-term fluctuations.
11. Evaluate the view that fiscal policy can be used to promote long-term economic growth (increases in
potential output) indirectly by creating an economic environment that is favorable 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.
Governments that have focus on getting the fundamentals
of economic management right can promote long-term
economic growth. They can worked to reduce their debt and
control inflation and put in place sustainable fiscal policies.
Indirectly governments can promote economic growth by
demonstrating sound and stable fiscal policies that
encourage private investment.
Directly by spending on infrastructure that encourage factor
mobility and promoting an education system that build a
population of skill labor that encourages private investment.
11. Evaluate the view that fiscal policy can be used to promote long-term economic growth (increases
in potential output) indirectly by creating an economic environment that is favorable 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.
Countries with higher levels of economic freedom substantially
outperform others in economic growth, per capita incomes,
health care, education, protection of the environment, and
reduction of poverty, according to data collected for the
2015 Index of Economic Freedom. Countries that have shown
long-term economic growth have scored well in the following
categories:
Rule of Law (property rights, freedom from corruption);
 Limited Government (fiscal freedom, government spending);
 Regulatory Efficiency (business freedom, labor freedom,
monetary freedom); and
 Open Markets (trade freedom, investment freedom, financial
freedom).
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12. 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.
Policy Lags:
The use of fiscal policy encounters time lags, or
policy lags, between the onset of an economic
problem, such as a business-cycle contraction, and
the full impact of the policy designed to correct the
problem.
A business-cycle contraction that hits the economy on
January 1st cannot be correct with fiscal policy by
January 2nd.
12. 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 goal of fiscal policy is to stabilize the business cycle, to
counter contractions and expansions. However, policy lags
can cause fiscal policy to destabilize the economy.
It can worsen the ups and downs of the business cycle. The
impact of expansionary fiscal policy to correct a businesscycle contraction, for example, might occur during the ensuing
expansion, which can then overstimulate the economy and
cause inflation.
Or the impact of contractionary fiscal policy designed to
reduce inflation might not occur until the onset of a
subsequent contraction. In both cases, the resulting policy is
not counter-cyclical, but pro-cyclical.
12. 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.
Four types of policy lags are common.
• Recognition Lag: This is the time it takes to identify the
existence of a problem. It takes time to obtain economic
measurements. Once data are obtained, it takes time to
analyze and evaluate the data to document the problem.
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Decision Lag: This is the time it takes to decide on a
suitable course of action, then pass whatever legislation,
laws, or administrative rules are needed. For fiscal policy,
this requires an act of Congress, signed into law by the
President. These decisions could take days, weeks, or
even months.
12. 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.
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Implementation Lag: This is the time it takes to implement the chosen
policy. A spending change requires actions by dozens, hundreds, or
even thousands of different government agencies, all of which need to
decide on to change their budgets. A tax change requires the
distribution of new tax rates and responses by those paying the taxes.
The implementation of fiscal policy is also likely to take weeks if not
months.
Impact Lag: This lag is the time it takes any change initiated by a
government policy to actually impact the producers and consumers in
the economy. A key part of the impact lag is the multiplier. A change in
government spending or taxes must work its way through the economy,
triggering subsequent changes in production and income, which induces
changes in consumption, which causes more changes in production and
income, which induces further changes in consumption. An impact lag of
one to two years is not uncommon.
12. 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.
CROWDING OUT: A decline in investment caused
by expansionary fiscal policy. When government
counteracts a recession with an increase in spending or
a reduction in taxes (both resulting in an increase in
the federal deficit) interest rates tend to increase.
Higher interest rates then inhibit business investment in
capital goods. To the extend that crowding out
occurs, economic growth is reduced if (and this is an
important if) government has not seen fit to offset the
loss in business investment with public investment in
infrastructure, education, or other growth promoting
expenditures.
CROWDING OUT
CROWDING OUT
CROWDING OUT
Crowding out
12. 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.
Political Problems:
 The government might have other priorities than economic
stability like providing public goods and services and
redistributing of income.
 State and local governments face constitutional
requirements to balance their budgets so would not be
able to deficit spend in a recession.
 There may be an expansionary bias among politicians who
find it hard to cut popular government programs or raise
taxes.
 Politicians goals might be to be reelected rather than
national economic goals.
12. 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.
Net Export Effect:
In the classical view, the expansionary fiscal policy also
decreases net exports, which has a mitigating effect on
national output and income.
When government borrowing increases interest rates it attracts
foreign capital from foreign investors. Therefore, when foreign
capital flows into the country undergoing fiscal expansion,
demand for that country's currency increases.
The increased demand causes that country's currency to
appreciate. Once the currency appreciates, goods originating
from that country now cost more to foreigners than they did
before and foreign goods now cost less than they did before.
Consequently, exports decrease and imports increase.
12. 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.
Net Export Effect:
Net Export Effect: Expansionary Fiscal Policy
Net Export Effect: Contractionary Fiscal Policy
12. 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 up sloping range of the aggregate supply curve
means that part of an expansionary fiscal policy may
be dissipated in inflation.
Less effect from the multiplier process.
12. 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.
Supply side and demand side shocks can lead to instability
in the economy.
Shocks are unexpected events that influence the demand /
supply in an economy.
Supply Side Shocks
These affect the costs and prices of supply
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These can include:
Technology
Natural disasters which impact the supply of particular goods
e.g. crops
Political situations that influence the supply of particular
products e.g. oil
Using information from the text/data and your knowledge of
economics, evaluate the role of fiscal policy in stimulating the
economy.
Positive role that fiscal policy may have:
 the effect direct investment may have on business
investment
 the possible effect on consumer spending and confidence
 lower production costs as a result of tax cuts in indirect
taxes
 direct tax cuts increase disposable income
 supply side benefits of increased government spending on
infrastructure
 possible increase in business confidence
 multiplier and accelerator effects
 impact on employment.
Using information from the text/data and your knowledge of
economics, evaluate the role of fiscal policy in stimulating the
economy.
Negative role fiscal policy may have:
 inflationary pressures conflicting with growth and the
desire to stimulate the economy
 is the package powerful enough to convince investors?
 inflexibility in that it cannot be changed easily and
quickly
 time lags for policy measures to have an effect
 financing a budget deficit
 “crowding out” effect of increased borrowing
 could add to the trade deficit. (Net Export Effect)
Evaluation of public spending of Fiscal Policy
The advantages:
 Public spending can have a considerable impact on the
level of aggregate demand, and compensate for failings
in other components of aggregate demand, such as a fall
in household spending on consumer goods and firms
spending on capital goods.
 If the spending is on capital items, then infrastructure can
be improved, and this can help improve economic growth.
 Public spending can be targeted to achieve a wide range
of economic objectives, such as reducing unemployment,
achieving more equity, road building, action against
poverty, and re-building city centers.
Evaluation of public spending of Fiscal Policy
The disadvantages:
 There may be a considerable time-lag between spending and
the benefits of spending. For example, a decision to increase
spending on education will take months to implement, and
years and decades to see the full benefits.
 In trying to promote growth or reduce unemployment
government spending can be inflationary, especially if the
government has to borrow from the financial markets or if the
spending is too fast, such as with an increase in current
spending on wages.
 There is a potential ‘trade off’ between unemployment and
inflation. If the aim of an increase in public spending is to
create jobs there is the strong possibility that inflation will be
created, and growth in jobs may only be temporary as the
economy readjusts to the previous level of unemployment.
Evaluation of tax policy of Fiscal policy
The advantages:
 Indirect taxes can be targeted very specifically at
altering behavior, such as ‘polluter pays’ taxes, and
taxes on demerit goods.
 Taxation can stabilize the macro-economy
automatically, through fiscal drag and boost.
 Discretionary changes in direct taxes can help
regulate aggregate demand.
 Taxes and welfare spending can also be used to help
reduce the income gap between rich and poor, reduce
poverty, and to help to promote equity
Evaluation of tax policy of Fiscal policy
The disadvantages:
 Changing tax rates, allowances and bands, is a highly
complex business, especially in comparison with changing
interest rates. Because of this changes are relatively infrequent,
with only small adjustments being made each year in the
annual budget.
 Households may increase or reduce their savings following
tax changes, so the effect on household spending of an
increase or decrease in taxes may be weak.
 There may be considerable time-lags between changing taxes
and changes in house -hold spending.
 Higher taxes may have a disincentive effect on work and
enterprise, as some individuals alter their perception of the
relative costs and benefits of work, in comparison with leisure.