Fiscal Policy

Definitions

• Fiscal policy is the term for when the government intervenes in the market using taxation or government spending.
• Fiscal policy is a type of demand-side policy.
  

Budget

• The government creates a budget yearly that outlines their revenue and how they plan to spend money.
  
• Budget deficit = government spending > government revenue
• Budget surplus = government spending < government revenue
• Balanced budget = government spending = government revenue
  

Government Revenue Resources

Direct and Indirect Taxation

• Direct taxes such as income taxes and indirect taxes such as sales tax, provides the government with revenue.
  

Sale of State-Owned Goods/Services

• State-owned businesses or enterprises often gain revenue such as airlines, postal services or oil companies.
  

Selling State-Owned Assets

• Privatization: the process of transferring ownership of a firm to the private sector from the government.
  

Types of Taxes

Direct Taxes

• Taxes placed directly on individuals are typically placed on income and wealth paid directly to the government.
• For example: income tax, corporate taxes, wealth taxes
  

Indirect Taxes

• Taxes placed on spending on goods and services paid indirectly to the government.
• Examples: sales tax, VAT, goods and services tax (GST), tariffs

Progressive, Regressive and Proportional Taxes

• All taxes can be placed into one of three categories

Progressive Taxes

• Taxation where the fraction/proportion of tax paid increases as income increases.
• Progressive income taxes separate people's incomes into separate tax brackets, which are each taxed at different rates.
  
• Average tax rate = tax/income
• This means that the average tax rate increases with increases in income.

Regressive Taxes

• Taxation where the fraction/proportion of tax paid increases as income decreases.
• All indirect taxes are regressive.

Proportional Taxes

• A system of taxation where tax is levied at a constant rate as income rises.

Government Spending

Current Expenditures

• The daily cost of keeping the government operational.
• For example salaries, armed forces, supplies.
  

Capital Expenditures

• The sum of all building and infrastructure financed by the government.
• For example building schools, fire stations, roads hospitals.
  

Transfer Payments

• A singular type of payment from the government to individuals typically to redistribute income or aid citizens.
• For example child support, unemployment payments, COVID stimulus payments.
  

Goals of Fiscal Policy

• Similar to Monetary Policy
• Low and stable inflation rate, low unemployment, promoting a stable environment for economic growth, reducing business cycle fluctuations, external balance.
  

Equitable Distribution of Income

• Through a progressive direct tax system and indirectly taxing luxury goods, the government can improve the distribution of income.
  

Expansionary Policy

• To correct a recessionary gap, governments would possibly use expansionary fiscal policy to increase aggregate demand.
• Expansionary fiscal policy is government spending and it increases AD.
• Expansionary policy is difficult as it often requires a budget deficit which can lead to debt.
• This can make it difficult to maintain their goal of a sustainable amount of debt.
• According to the neoclassical theory, government spending is not needed.
  

Contractionary Policy

• To correct an inflationary gap, governments would possibly use expansionary fiscal policy to decrease aggregate demand.
• Contractionary fiscal policy is taxation and it decreases AD.
  
• According to neoclassical theory, taxation is not needed as the inflationary gap will correct itself.
  

Fiscal Policy Strengths

• Able to target specific sectors of an economy
• Effective in a recession (automatic stabilizers)
• Direct impact of AD
• Government intervention is required for Keynesian view
  

Limitations of Fiscal Policy

• Politices
• Differing political parties have different beliefs on what is best for the economy.
• These differences frequently lead to longer response times.
  

Time Lags

• The government takes time to notice a problem, develop a policy, and then implement that policy.
  These policies take time to be effective.
  

Sustainable Debt

• Governments must spend money to stimulate the economy if needed.
• These expenditures compile and may turn into large amounts of debt.
  

Crowding Out

• When government spending on the public sector drives down the private sector spending (consumption and investment).
  

Targeted

• It is hard to make it achieve specific targets.
• It is difficult to predict the precise outcome of any fiscal policy.
  

Debt

• Debt is the total amount of money that a government owes to its creditors, both domestic and foreign.
• For example owners of bonds and central banks from which loans are taken.
• Accumulation of budget deficit, leads to debt.
• Debt is often expressed as a percentage of GDP.
  

Negative Effects of Debt

• Crowding out
  
• Interest payments are a part of government expenditure.
• More debt leads to a higher percentage of government expenditure that needs to go to interest payments.
  
• Requires higher levels of taxes to fund expenditure.
  
• High debt may decrease the ability of governments to respond to emergencies.

Keynesian Multiplier

• When the government spends money, there is a far larger affect on aggregate demand than just the value of the injection itself.
• This is called the Keynesian multiplier.
• For example, if a government pays a firm $100 million to build a new highway, then that firm buys raw materials pays households with wages who then spend those wages, leading to an overall increase in AD greater than $100 million.
  

Circular Flow and Government Spending

Marginal Propensity to Save (MPS)

• MPS is the proportion of income that households choose to save.
  

Marginal Rate of Taxation (MRT)

• MRT is the proportion of income that households pay in taxes.
  

Marginal Propensity to Consume (MPC)

• MPC is the proportion of income that households choose to spend and that affects domestic economy.
  

Marginal Propensity to Import (MPM)

• MPI is the proportion of income that households choose to spend on imported goods.

Examples

Building a New School Scenario

• The government contracts out this building and hires a construction company.
• This construction company must then purchase resources to build this school.
• Additionally, they hire more employees for the job.
• Households now recieve more income.
• Households will either spend or save that income.

Highway Scenario

• Assume Households MPC = 30% or 0.3
• Households spend 30% of the additional income they receive 0.3*$100 million = $30 million
• Firms must now adjust their inventory due to the increase in spending.
• This requires more factors of production to be purchased.
• Households now have additional income and are now spending an additional 0.3*$30 million = $9 million.
  
• The chain reaction would continue until the $100 million initial government spending would result in a $142 million outcome.
• The chain continues until the change is negligibly small.
  

Calculating the Keynesian Multiplier

• As households will spend the money they recieve multiplied by the MPC every time they receive money, this will lead to a loop that is modelled as a geometric series.
  
• The sum of an infinite geometric series where the multiplier is less than 1 is written as 1/(1-multiplier).
• Thus the Keynesian multiplier is written as:
• Multiplier = 1/(1-MPC)
• Where MPC is written as a decimal number.
  
• There is an alternative way to measure the multiplier.
• It is defined as:
• Multiplier = 1/(MPS + MPT + MPM)
  
• This works because MPS, MPT and MPM are all activities that do not make the economy grow.
• Therefore:
• the proportion of income that does not make the economy grow =1-the proportion of income that does make the economy grow.
  

Calculating the Change in GDP

• Change in GDP = Keynesian multiplier*the change in expenditure
  

Crowding Out

• Crowding out is when government spending on the public sector drives down private sector spending.
  This means an increase in government spending can reduce consumption and investment.
  

Example

• If the government decides to build a new school they must increase their spending.
  The government must demand more money resulting in an increase to the overall interest rate.
• As interest rates rise, firms will find it too expensive to invest in new projects and spending.
• This results in a decrease in consumption and investment.

• Fiscal policy should lead to a readjustment of AD to equilibrium (AD -> AD1).
• However, due to crowding out, investment and consumption fall, resulting in a decrease to AD2.

Automatic Stabilizers

• Fiscal policies has two underlying policies which are automatic stabilizers.
• These are progressive income taxes (taxation) and unemployment benefits (government spending).
• These reduce business cycle fluctuations without an government intervention and occur automatically.

• Progressive income taxes function as an automatic stabilizer, as with increases in income they will tax progressively more, discouraging increasing consumption further.
  
• Progressive taxes also tax progressively less when people are making less income, meaning it encourages consumption during a recession where wages are reduced.

• Unemployment benefits allow people who have no jobs to still have some income, meaning they can continue to consume.
• With these benefits, it is hoped that people will continue to consume even if they lose their job during a recession.
• Unemployment benefits only affect those who don't have jobs, meaning it doesn't boost consumption during an expansion.
  

Economic Recession

• Unemployment rises and the government spends more on unemployment benefits.
• For those that keep their jobs, wages fall with Average Price Level.
• Lower wages push individuals into a lower tax bracket, allowing them to save money.
• Decrease government tax revenue.
  
• An increase in government spending and a decrease in taxes will encourage consumption and increase aggregate demand so that the economy returns to full employment.
  

Economic Expansion

• Unemployment falls and the government spends less on unemployment benefits.
• As individuals are hired and recieve an increase in wages, they are pushed into a higher tax bracket meaning that they pay more income tax.
• Increase government tax revenue.

• A decrease in government spending and an increase in taxes will slow down the economy to combat the inflation and return to full employment.