Subject 7. Fiscal Policy: Roles, Objectives, and Tools

Fiscal policy refers to the use of government expenditure, tax, and borrowing activities to achieve economic goals, including the overall level of aggregate demand in an economy (and hence the level of economic activity), the distribution of income and wealth among different segments of the population, and, ultimately, the allocation of resources between different sectors and economic agents.

Government expenditures include transfer payments, the purchase of goods and services (current government spending), and capital expenditure.

Government revenues are generated through taxes. There are direct and indirect taxes. Direct taxes are difficult to change without considerable notice. Indirect taxes can be adjusted almost immediately.

The four desirable attributes of a tax policy are simplicity, efficiency, fairness, and revenue sufficiency.

A budget is the annual statement of the government's expenditures and tax revenues. A balanced budget implies that current government revenue is equal to current government expenditures.

A budget deficit exists when total government spending exceeds government revenue. A budget deficit is financed through the issuance of government securities. Such issuance of securities adds to the national debt.

A budget surplus occurs when revenues exceed spending. Under a budget surplus, excess revenue is applied to the total outstanding debt accumulated during prior periods, therefore reducing it by the amount of the surplus.

There are arguments for and against being concerned with the size of a fiscal deficit.

The arguments against being concerned about national debt:

  • The debt is owed internally by fellow citizens.
  • Some borrowed money may have been used for capital investment projects or enhancing human capital.
  • Large deficits require tax changes which may be desirable.
  • Richardian equivalence: the timing of any tax change does not affect consumers' change in spending.
  • Debt could improve employment.

The arguments for being concerned about national debt:

  • Higher deficits -> higher tax rates -> less incentive to work and invest -> lower long-term growth
  • The central bank may have to print money to finance a deficit. This may lead to high inflation.

The crowding-out effect is the reduction in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing in the capital market. It suggests that budget deficits will exert less impact on aggregate demand than the basic Keynesian model implies. Because financing the deficit pushes up interest rates, budget deficits will tend to retard private spending, particularly spending on investment. This reduction will at least partially offset additional spending emanating from the deficit.

Multipliers

As disposable income increases, consumption expenditures increase, but by a smaller fraction than the increase in income. This is reflected in the marginal propensity to consume (MPC), which is less than one.

Marginal propensity to save (MPS) is defined as additional savings divided by additional current disposable income.

MPC + MPS = 1
If we add tax rate t, then:

MPC + MPS = 1 - t
An expenditure multiplier is the ratio of the change in equilibrium output relative to the independent change in consumption, investment, and government spending or spending on net exports that brings about the change.

The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. It exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.

The tax multiplier is the magnification effect a change in taxes on aggregate demand. An increase in taxes decreases disposable income, which decreases consumption expenditure, aggregate expenditure, and real GDP.

The two multipliers are called the fiscal multiplier: 1/[1 - c (1 - t)], where c is the MPC and t is the tax rate.

The balanced budget multiplier is the magnification effect of a simultaneous change in government purchases and taxes on aggregate demand. A $1 increase in government purchases increases aggregate demand initially by $1, but a $1 increase in taxes decreases consumption expenditure by less than $1 initially, so a $1 increase in both purchases and taxes increases aggregate demand.

The structural surplus or deficit is the surplus or deficit that would occur if the economy was at full employment and real GDP was equal to potential GDP.

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