Download fiscal policy - Oldfield Economics

FISCAL POLICY
Fiscal policy is one of the key macroeconomic tools of the government. Fiscal
policy involves the use of government expenditure and taxation to influence
the economy. Keynesian economists tend to concentrate on the effects that
Fiscal Policy has on AD, whilst Classical/Supply-Side economists also look at the
effect that Fiscal Policy has on AS.
Fiscal Policy and AD.
A rise in government expenditure, or a fall in taxation, should increase
aggregate demand and boost employment. The size of the resulting final
change in equilibrium national income is determined by the multiplier effect.
This is where an initial increase in expenditure leads to a higher overall
increase in income, as people pass on the money (this is studied in detail at
HL).eg the 2000bt Government handout will be spent in shops, the shopkeepers
then spend this and so on.
Automatic Stabilisers and Discretionary Fiscal Policy
Automatic stabilisers describe what happen to Government expenditure and
taxation, when there are changes in the economic cycle, even though the
Government does not change any of its policies. For example, when in a
recession we expect to see a rise in government spending (transfer payments)
and a fall in tax revenues, which would reduce the impact of the economic
slowdown. Likewise, during a boom, the tax system takes a rising share of
national income from households and companies (in part this is because of the
progressive system of direct taxation). When demand and incomes are
increasing, the government will see a strong flow of extra tax revenue - money
that leaves the circular flow of income and spending. Discretionary or active
fiscal policy refers to the deliberate changing of government policy which
expenditure levels and tax rates. The government might decide to boost
government spending and run a budget deficit in a clear attempt to inject
extra aggregate demand into the economy and boost short-term growth.
Problems with the use of fiscal policy when managing aggregate demand
In simple economic theory the economic cycle can be managed by
fiscal policy. However, in reality the situation is far more complex. Why?
 Time lags. It takes time to recognise that AD is growing either too
quickly or too slowly. It then takes time to introduce an appropriate
policy.It takes time for the policy to work, as the multiplier process is
not instantaneous.
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the national income multiplier. (HL only) 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 multiplier was 4, a rise of only£250m would be needed. Without
knowing the precise value of the multiplier it is difficult to fine-tune the
economy accurately.
Fiscal Crowding-Out If the government attempts to reflate the economy
by reducing taxation, or by increasing government spending, then this
may lead to a budget deficit. To finance the deficit the government will
have to sell debt to the private sector. Attracting individuals and
institutions to purchase the debt the government may have to increase
interest rates. This rise in interest rates may “crowd out” (reduce)
private investment and consumption and reduce the fiscal stimulus to
the economy. Also if people are buying bonds then there may not be
sufficient funds for the private sector to borrow. In reality in modern
economies, with sophisticated international financial markets, it is
unlikely that firms will not be able to gain finance, so this effect is not
particularly strong. (How has this last sentence changed in 2008-9? Firms
are finding it difficult to gain finance)
Public Sector Finances - Government Borrowing and Debt Repayment
The Public Sector Net Cash Requirement (PSNCR) is the financial
deficit of the Government. When the government is running a budget deficit it
means total public expenditure exceeds revenue. As a result, the government
has to borrow through the issue of government debt (bonds). It is also
sometimes referred to as the Public Sector Borrowing Requirement (PSBR) or
Budget deficit. When the Government has more revenue than it spends it is
able to reduce its debts by using the excess revenue to buy back some of the
bonds. It is therefore referred to as the Public Sector Debt Repayment (PSDR).
None of the above should be confused with the term “National Debt” which is
something different! The national debt is the total borrowing undertaken by
central government, which has not yet been repaid. In other words, it is the
sum of all outstanding government debt. Eg If the Government has the
following PSBRs calculate the National Debt
 Yr 1 PSBR 100 rmb
 Yr 2 PSDR 40 rmb
 Yr 3 PSBR 60 rmb
National Debt=
Does it matter if the government is running a large budget deficit?
There is a general agreement amongst economists that a persistently large
budget deficit can be a major problem for the government and the economy:
It has to be financed
Issuing government debt to domestic or overseas investors can do this. In a
world where money flows freely between countries it can be relatively easy to
finance a deficit - but it may require higher interest rates to attract buyers of
debt. This in turn will have a negative effect on economic growth. In 2009 this
has become a major issue. National debts are increasing significantly and it is
being questioned whether some countries can actual finance these. Once the
market feels that a country cannot finance its deficit then it is harder for
Governments to sell bonds.
In the long run, a high PSNCR adds to the accumulated National Debt.
This means that the Government has to pay more each year in debt interest
charges. There is an opportunity cost here. That spending could be used in
more productive ways.
It also represents a transfer of income from people who pay taxes to those
who hold government debt. A high PSNCR may therefore cause a redistribution
of income and wealth in the economy. This is controversial at the moment.
Much Government expenditure is going to help Banks who made losses due to
incompetence and greed.(?) Future generations of taxpayers are bailing them
out? Fair?
"Today's borrowing is tomorrow's taxes"
Eventually the deficit has to be reduced. This can be achieved by cutting public
sector spending, but the normal way is to increase the tax burden.
However there are circumstances in which it could be argued that a budget
deficit is not a problem:
Keynesian theory argues that a PSNCR is a stimulus to AD - something that
might be necessary in a deep recession or economic slump. However if the
Government is running a PSNCR in a boom, then there maybe something
fundamentally wrong.
Many now see it as an objective to balance the budget over the economic
cycle.
Government Borrowing and Asset Accumulation
A PSNCR may have positive effects in the long run if it is being used to finance
capital spending that leads to an increase in the productive potential of an
economy. Again there has been a big debate about this in China. Due to the
world recession in 2009 the Chinese Government implemented one of the
largest fiscal stimulus programmes ever seen. But was this efficient investment
or was it simply leading to huge amounts of spare capacity in industries where
consumers were disinterested in purchasing their output. (was the Shanghai
expo worthwhile would be a good debate on this- many buildings were simply
demolished after the Expo finished but we still have a vastly improved metro
system (underground) Spending on the infrastructure improves the supply-side
capacity of the economy promoting long-run economic growth. Nowhere is this
more obvious than here in Jakarta. However if excess spending is wasted on
non productive projects then there will be no returns on this spending in the
future. Do bailouts by the US government to AIG to allow them to pay bonuses
to bosses really lead to promoting long term economic growth? How much
Government expenditure is embezzled in Indonesia?
Fiscal Policy and AS
However fiscal policy is also used to influence the supply-side of the
economy. For example, changes in fiscal policy can affect individual markets
and industries and change the incentives for people to look for work and for
companies to invest.
Taxation and Work Incentives
Can changes in income tax affect the incentive to work? Consider the impact of
an increase in the rate of income tax. The rise in tax has the effect of reducing
the income after tax of those in work. For each hour of work taken the total
net income is now lower. This might encourage the individual to work more
hours to maintain his/her income. However, the effect might be to encourage
less work since the tax might act as a disincentive to work. Of course many
workers have little flexibility in the hours that they work. They will be
contracted to work a certain number of hours, and changes in direct tax
rates will not alter that.
If tax and welfare benefit reforms can successfully improve work incentives and
thereby lead to an increase in the active labour supply, this will help to reduce
unemployment
Taxation - Investment and long Run Aggregate Supply
Lower rates of corporation tax and other business taxes can stimulate an
increase in business investment spending. The government might also use tax
allowances to stimulate increases research and development and encourage an
increase in the rate of small business start-ups. A favourable tax regime could
also be attractive to inflows of foreign direct investment – a stimulus to the
economy that might benefit both aggregate demand and supply.
Investment should not be seen solely in terms of the purchase of new
machines. Changes to the tax system and specific areas of government
spending might also be used to stimulate investment in technology, innovation,
the skills of the labour force and social infrastructure. A good example of this
might be a substantial increase in real government spending on the transport
infrastructure. Improvements in our transport system would add directly to
aggregate demand, but would also provide a boost to productivity and
competitiveness.