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SAYRE | MORRIS Seventh Edition CHAPTER 7 Fiscal Policy © 2012 McGraw-Hill Ryerson Limited 7-1 LO1 Fiscal Policy Fiscal Policy • Government’s approach toward its own spending and taxation • Minister of finance brings down annual budget in Parliament each spring • Contains estimates of government’s revenues and expenditures © 2012 McGraw-Hill Ryerson Limited 7-2 LO1 Table 7.1 Federal Government Budget Year Ending March 2010 REVENUES Personal income taxes Corporate and other income taxes E.I. premiums GST and excise and energy taxes Nontax revenues Total Revenues OUTLAYS Transfers to persons Spending grants to other levels of govt Public debt charges Direct program spending Total Outlays Projected Budget Plan Deficit 103.9 36.0 16.8 40.6 21.6 218.6 68.6 57.0 29.4 119.2 274.2 55.6 Source: Data derived by authors from information found in Department of Finance; Annual Report to the Government 2009-2010. Reproduced with the permission of the Minister of Public Works and Government Services, 2010. © 2012 McGraw-Hill Ryerson Limited 6-3 Fiscal Policy LO1 Net Tax Revenue • total tax revenue received by government less transfer payments NTR = tax revenue transfer payments Budget Balance • the difference between net tax revenues and government spending Budget Balance = NTR - G © 2012 McGraw-Hill Ryerson Limited 7-4 LO1 Fiscal Policy Budget Surplus • net tax revenue in excess of government spending on goods and services Budget Deficit • government spending on goods and services in excess of net tax revenues © 2012 McGraw-Hill Ryerson Limited 7-5 LO1 Fiscal Policy National Debt • the sum of the federal government’s budget deficits less its surpluses Balanced Budget • the equality of net tax revenues and government spending on goods and services © 2012 McGraw-Hill Ryerson Limited 7-6 LO1 Table 7.2 Net National Debt (current $ billion) Year 1940 1963 1973 1983 1993 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Budget Surplus — — — — — — 3.0 5.8 14.3 19.9 8.0 6.6 9.1 1.5 13.2 13.8 9.6 — — Budget Deficit 0.1 0.8 1.9 29.0 39.0 8.7 — — — — — — — — — — — −5.8 −55.6 Net National Debt 3.3 15.7 24.0 136.7 449.0 562.9 559.9 554.1 539.9 520.0 511.9 505.3 496.2 494.7 481.5 467.3 457.6 463.7 519.1 Department of Finance: Fiscal Reference tables October 2010. © 2012 McGraw-Hill Ryerson Limited 6-7 LO1 © 2012 McGraw-Hill Ryerson Limited 7- 8 LO1 © 2012 McGraw-Hill Ryerson Limited 7- 9 LO1 Fiscal Policy The government budget is affected by: • the level of the GDP • A change in the amount of government spending • A change in the amount of government revenue (taxation) © 2012 McGraw-Hill Ryerson Limited 7-10 LO2 Countercyclical Fiscal Policy John Maynard Keynes: • Developed model in response to the depression • Based on aggregate expenditures: AE = C + I + G + Xn • Believed depression was caused by decreased aggregate expenditures • Argued for increased government expenditures to increase employment and incomes • Increased spending financed through borrowing © 2012 McGraw-Hill Ryerson Limited 7-11 LO2 Counter-Cyclical Fiscal Policy Potential GDP P Dealing with a recessionary gap: - raise G and/or lower T - total spending increases to AD2 - shifts economy back to potential GDP AS1 G Recessionary gap AD2 AD1 Y1 YFE Real Y Chapter 11-12 LO2 Counter-Cyclical Fiscal Policy Potential GDP P Dealing with an inflationary gap: - lower G and/or raise T - total spending decreases to AD2 - shifts economy back to potential GDP AS1 G Inflationary gap AD1 AD2 YFE Y1 Real Y Chapter 11-13 LO2 Countercyclical Fiscal Policy Summary: • When there is a recessionary gap, governments should spend and tax in a way that increases aggregate demand. • When there is an inflationary gap, governments should spend and tax in a way that reduces aggregate demand. © 2012 McGraw-Hill Ryerson Limited 7-14 LO2 Countercyclical Fiscal Policy Shortcomings: • it is subject to serious time lags • it has an inflationary bias • it can cause serious budget deficits © 2012 McGraw-Hill Ryerson Limited 7-15 LO3 Balanced Budget Fiscal Policy • the government budget is balanced in each fiscal period • addresses the shortcomings of a countercyclical fiscal policy • relies on automatic stabilizers (tax laws and spending programs that cut back spending during a boom and increase spending in a slowdown) • based on belief that economy will return to full employment on its own © 2012 McGraw-Hill Ryerson Limited 7-16 LO2 Balanced Budget Fiscal Policy P Potential GDP AS1 Wages AS2 Recessionary gap AD Y1 YFE Recessionary gap: - eventually wages will be forced down -AS increases, returning economy to YFE - also decreases price level AS would increase because we know that when a productive resource decreases (wages), supply increases. Real Y Chapter 11-17 LO3 Balanced Budget Fiscal Policy Shortcomings: • Procyclical: pushing the economy further in the same direction it is going • balanced budget is procyclical in a recessionary gap, because low tax revenues create deficits • may be procyclical in an inflationary gap, if it is accompanied by a budget surplus © 2012 McGraw-Hill Ryerson Limited 7-18 Cyclically Balanced Budget Fiscal Policy LO4 • the use of countercyclical fiscal policy to balance the budget over the life of the business cycle • no guarantee that size and length of recessionary gap will be exactly offset by the size and length of the inflationary gap • most governments find it easier to increase spending in bad times than to decrease it in good times © 2012 McGraw-Hill Ryerson Limited 7-19 LO5 Fiscal Policy and National Debt • government borrows by issuing bonds • debt held by individuals, corporations, and financial institutions • interest payments represent redistribution of wealth from all taxpayers to relatively wealthy bondholders © 2012 McGraw-Hill Ryerson Limited 7-20 LO5 © 2012 McGraw-Hill Ryerson Limited 7- 21 LO5 Fiscal Policy and National Debt • debt increased significantly to finance WWII • debt increased again since 1970s • increase in income-support programs • high interest rates in 1970s and 1990s • since 1995, Canada’s debt fell to lowest of G8 © 2012 McGraw-Hill Ryerson Limited 7-22 LO5 Fiscal Policy and National Debt Problems with High Deficits / Debt: • the interest payments that must be paid on the foreign-held debt • the income redistribution effects of large interest payments • the reduced ability of government to meet the needs of its citizens • the possible increased power grabbing and wastefulness of government © 2012 McGraw-Hill Ryerson Limited 7-23 © 2012 McGraw-Hill Ryerson Limited 7- 24