Reading 14

Fiscal policy refers to a government's use of spending and taxation to influence economic activity. The budget is said to be balanced when tax revenues equal government expenditures. A budget surplus occurs when government tax revenues exceed expenditures, and a budget deficit occurs when government expenditures exceed tax revenues. An increase in the deficit (or a decrease in a surplus) is considered expansionary in that it tends to increase GDP. A decrease in a deficit (or increase in a surplus) is considered contractionary in that it tends to decrease GDP.

Monetary policy refers to the central bank's actions that affect the quantity of money and credit in an economy to influence economic activity. Monetary policy is said to be expansionary (or accommodative or easy) when the central bank increases the quantity of money and credit in an economy. Conversely, when the central bank is reducing the quantity of money and credit in an economy, monetary policy is said to be contractionary (or restrictive or tight).

Policymakers use both monetary and fiscal policies with the goals of maintaining stable prices and producing positive economic growth. Fiscal policy can also be used as a tool for redistribution of income and wealth.

Objectives of fiscal policy may include the following:

• Influencing the level of economic activity and aggregate demand
• Redistributing wealth and income among segments of the population
• Allocating resources among economic agents and sectors in the economy

In general, decreased taxes and increased government spending both increase a budget deficit, overall demand, economic growth, and employment; increased taxes and decreased government spending decrease these. Budget deficits are increased in response to recessions, and budget deficits are decreased to slow growth when inflation is too high.

Keynesian economists believe that fiscal policy, through its effect on aggregate demand, can have a strong effect on economic growth when the economy is operating at less than full employment. Monetarists believe that the effect of fiscal stimulus is only temporary, and that monetary policy should be used to increase or decrease inflationary pressures over time. Monetarists do not believe that monetary policy should be used in an attempt to influence aggregate demand to counter cyclical movements in the economy.

Discretionary fiscal policy refers to the spending and taxing decisions of a national government that are intended to stabilize the economy. In contrast, automatic stabilizers are built-in fiscal devices triggered by the state of the economy. For example, during a recession, tax receipts will fall, and government expenditures on unemployment insurance payments will increase. Both of these tend to increase budget deficits and are expansionary. Similarly, during boom times, higher tax revenues coupled with lower outflows for social programs tend to decrease budget deficits and are contractionary.

When a government runs fiscal deficits, it incurs debt that needs to be repaid as well as ongoing interest expense. Total deficits, annual deficits, and interest expense can all be evaluated relative to annual GDP. When these ratios increase beyond certain levels, it may be a cause for concern, and the solvency of the country may be questioned.

A country's debt ratio is the ratio of aggregate debt to GDP. Because taxes are linked to GDP, when an economy grows in real terms, so will tax revenues. If the real interest rate on the government's debt is higher than the real growth rate of the economy, then the debt ratio will increase over time (keeping tax rates constant). Similarly, if the real interest rate on the government's debt is lower than real growth in GDP, the debt ratio will decrease (i.e., improve) over time.

Arguments for being concerned with the size of a fiscal deficit are as follows:

• Higher deficits lead to higher future taxes. Higher future taxes will lead to disincentives to work and entrepreneurship. This leads to lower long-term economic growth.
• If markets lose confidence in the government, investors may not be willing to refinance the debt. This can lead to the government defaulting (if debt is in a foreign currency) or having to simply print money (if the debt is in local currency). Printing money would ultimately lead to higher inflation.
• Increased government borrowing will tend to increase interest rates, and firms may reduce their borrowing and investment spending as a result, thus decreasing the impact on aggregate demand of deficit spending. This is referred to as the crowding-out effect because government borrowing is taking the place of private-sector borrowing.

Arguments against being concerned with the size of a fiscal deficit are as follows:

• If the debt is primarily held by domestic citizens, the scale of the problem is overstated.
• If the debt is used to finance productive capital investment, future economic gains will be sufficient to repay the debt.
• Fiscal deficits may prompt needed tax reform.
• Deficits would not matter if Ricardian equivalence holds, which means private-sector savings in anticipation of future tax liabilities just offset the government deficit.
• If the economy is operating at less than full capacity, deficits do not divert capital away from productive uses and can aid in increasing GDP and employment.

Fiscal policy tools include spending tools and revenue tools.

Spending Tools

Transfer payments, also known as entitlement programs, redistribute wealth, taxing some and making payments to others. Examples include government-run retirement income plans (such as Social Security in the United States) and unemployment insurance benefits. Transfer payments are not included in GDP computations.

Current spending refers to government purchases of goods and services on an ongoing and routine basis.

Capital spending refers to government spending on infrastructure, such as roads, schools, bridges, and hospitals. Capital spending is expected to boost future productivity of the economy.

Spending tools are commonly justified as means of pursuing the following goals:

• Provide services such as national defense that benefit all the residents in a country.
• Invest in infrastructure to enhance economic growth.
• Support the country's growth and unemployment targets by directly affecting aggregate demand.
• Provide a minimum standard of living.
• Subsidize investment in research and development for certain high-risk ventures consistent with future economic growth or other goals (e.g., green technology).

Revenue Tools

Direct taxes are levied on income or wealth. These include income taxes, taxes on income for national insurance, wealth taxes, estate taxes, corporate taxes, capital gains taxes, and Social Security taxes. Some progressive taxes (such as income taxes and wealth taxes) collect revenue for wealth and income redistribution.

Indirect taxes are levied on goods and services. These include sales taxes, value-added taxes (VATs), and excise taxes. Indirect taxes can be used to reduce consumption of some goods and services (e.g., alcohol, tobacco, gambling).

Desirable attributes of tax policy are as follows:

• Simplicity to use and enforce
• Efficiency, defined here as minimizing interference with market forces and not acting as a deterrent to working
• Fairness — two of the commonly held beliefs are horizontal equality (people in similar situations should pay similar taxes) and vertical equality (richer people should pay more in taxes)
• Sufficiency, in that taxes should generate enough revenues to meet the spending needs of the government

Advantages of fiscal policy tools include:

• Social policies (e.g., discouraging tobacco use) can be implemented quickly via indirect taxes.
• Quick implementation of indirect taxes also means that government revenues can be increased without significant additional costs.

Disadvantages of fiscal policy tools include:

• Direct taxes and transfer payments take time to implement, delaying the impact of fiscal policy.
• Capital spending also takes a long time to implement; the economy may have recovered by the time its impact is felt.

Announcing a change in fiscal policy may have significant effects on expectations. For example, an announcement of a future increase in taxes may immediately reduce current consumption, rapidly producing the desired goal of reducing aggregate demand.

Not all fiscal policy tools affect economic activity equally. Spending tools are most effective in increasing aggregate demand. Tax reductions are somewhat less effective, as people may not spend the entire amount of the tax savings. Tax reductions for those with low incomes will be more effective in increasing aggregate demand, as those with lower incomes tend to spend a larger proportion of income on consumption; that is, they save a smaller proportion of income and have a higher marginal propensity to consume (MPC).

Fiscal Multiplier

Changes in government spending have magnified effects on aggregate demand because those whose incomes increase from increased government spending will, in turn, increase their spending, which increases the incomes and spending of others. The magnitude of the multiplier effect depends on the tax rate and on the marginal propensity to consume.

To understand the calculation of the multiplier effect, consider an increase in government spending of $100 when the MPC is 80% and the tax rate is 25%. The increase in spending increases incomes by $100, but $25 ($100 × 0.25) of that will be paid in taxes. Disposable income is equal to income after taxes, so disposable income increases by $100 × (1 − 0.25) = $75. With an MPC of 80%, additional spending by those who receive the original $100 increase is $75 × 0.8 = $60.

This additional spending will increase others' incomes by $60 and disposable incomes by $60 × 0.75 = $45, from which they will spend $45 × 0.8 = $36.

Because each iteration of this process reduces the amount of additional spending, the effect reaches a limit. The fiscal multiplier determines the potential increase in aggregate demand resulting from an increase in government spending:

\[\text{fiscal multiplier} = \dfrac{1}{1 - \text{MPC}(1 - t)}\]

Here, with a tax rate of 25% and an MPC of 80%, the fiscal multiplier is \(1 / [1 - 0.8(1 - 0.25)] = 2.5\), and the increase of $100 in government spending has the potential to increase aggregate demand by $250.

The fiscal multiplier is inversely related to the tax rate (higher tax rate decreases the multiplier) and is directly related to the marginal propensity to consume (higher MPC increases the multiplier).

Balanced Budget Multiplier

To balance the budget, the government could increase taxes by $100 to just offset a $100 increase in spending. Changes in taxes also have a magnified effect on aggregate demand. An increase in taxes will decrease disposable income and consumption expenditures, thereby decreasing aggregate demand. The initial decrease in spending from a tax increase of $100 is $100 × MPC = 100 × 0.8 = $80; beyond that, the multiplier effect is the same as we described for a direct increase in government spending, and the overall decrease in aggregate demand for a $100 tax increase is $100(MPC) × fiscal multiplier — or, for our example, $100(0.8)(2.5) = $200.

Combining the total increase in aggregate demand from a $100 increase in government spending with the total decrease in aggregate demand from a $100 tax increase shows that the net effect on aggregate demand of both is an increase of $250 − $200 = $50, so we can say that the balanced budget multiplier is positive.

If, instead of a $100 increase in taxes, we increased taxes by $100 / MPC = 100 / 0.8 = $125 and increased government spending by $100, the net effect on aggregate demand would be zero.

Ricardian Equivalence

Increases in the current deficit mean greater taxes in the future. To maintain their preferred pattern of consumption over time, taxpayers may increase current savings (reduce current consumption) to offset the expected cost of higher future taxes. If taxpayers reduce current consumption and increase current saving by just enough to repay the principal and interest on the debt the government issued to fund the increased deficit, there is no effect on aggregate demand. This is known as Ricardian equivalence, after economist David Ricardo. If taxpayers underestimate their future liability for servicing and repaying the debt so that aggregate demand is increased by equal spending and tax increases, Ricardian equivalence does not hold. Whether it does is an open question.

Fiscal policy is implemented through changes in taxes and spending. This is called discretionary fiscal policy (as opposed to automatic stabilizers, discussed previously). Discretionary fiscal policy would be designed to be expansionary when the economy is operating below full employment. Fiscal policy aims to stabilize aggregate demand. During recessions, actions can be taken to increase government spending or decrease taxes. Either change tends to strengthen the economy by increasing aggregate demand, putting more money in the hands of corporations and consumers to invest and spend. During inflationary economic booms, actions can be taken to decrease government spending or increase taxes. Either change tends to slow the economy by decreasing aggregate demand, taking money out of the hands of corporations and consumers and causing both investment and consumption spending to decrease.

Discretionary fiscal policy is not an exact science. First, economic forecasts might be wrong, leading to incorrect policy decisions. Second, complications arise in practice that delay both the implementation of discretionary fiscal policy and the impact of policy changes on the economy. The lag between recessionary or inflationary conditions in the economy and the impact on the economy of fiscal policy changes can be divided into three types:

1. Recognition lag. Discretionary fiscal policy decisions are made by a political process. The state of the economy is complex, and it may take policymakers time to recognize the nature and extent of the economic problems.
2. Action lag. Governments take time to discuss, vote on, and enact fiscal policy changes.
3. Impact lag. Time elapses between the enactment of fiscal policy changes and when the impact of the changes on the economy actually takes place. It takes time for corporations and individuals to act on the fiscal policy changes, and fiscal multiplier effects occur only over time as well.

These lags can actually make fiscal policy counterproductive. For example, if the economy is in a recession phase, fiscal stimulus may be deemed appropriate. However, by the time fiscal stimulus is implemented and has its full impact, the economy may already be on a path to a recovery driven by the private sector.

Additional macroeconomic issues may hinder the usefulness of fiscal policy:

• Misreading economic statistics. The full employment level for an economy is not precisely measurable. If the government relies on expansionary fiscal policy mistakenly at a time when the economy is already at full capacity, it will simply drive inflation higher.
• Crowding-out effect. Expansionary fiscal policy may crowd out private investment. Greater government borrowing tends to increase interest rates, which decreases private investments (some investments will be uneconomic with higher borrowing costs). This crowding-out effect can reduce the impact of expansionary fiscal policy on aggregate demand. Opinions vary on the magnitude of this effect.
• Supply shortages. If economic activity is slow due to resource constraints (low availability of labor or other resources) and not due to low demand, expansionary fiscal policy will fail to achieve its objective and will probably lead to higher inflation.
• Limits to deficits. There is a limit to expansionary fiscal policy. If the markets perceive that the deficit is already too high as a proportion of GDP, funding the deficit will be problematic. This could lead to higher interest rates and actually make the situation worse.
• Multiple targets. If the economy has high unemployment coupled with high inflation, fiscal policy cannot address both problems simultaneously.

To determine if fiscal policy is expansionary or contractionary, economists often focus on changes in the budget surplus or deficit. An increase (decrease) in surplus is indicative of a contractionary (expansionary) fiscal policy. Similarly, an increase (decrease) in deficit is indicative of an expansionary (contractionary) fiscal policy.

A government's intended fiscal policy is not necessarily obvious from just examining the current deficit. Consider an economy that is in recession so that transfer payments are increased and tax revenue is decreased, leading to a deficit. This does not necessarily indicate that fiscal policy is expansionary as, at least to some extent, the deficit is a natural outcome of the recession without any explicit action of the government. Economists often use a measure called the structural budget deficit (or cyclically adjusted budget deficit) to gauge fiscal policy. This is the deficit that would occur based on current policies if the economy were at full employment.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 14.1

1. B — Both monetary and fiscal policies primarily strive to achieve economic targets such as inflation and GDP growth. Balancing the budget is not a goal for monetary policy and is a potential outcome of fiscal policy. Fiscal policy (but not monetary policy) may secondarily be used as a tool to redistribute income and wealth. (LOS 14.a)

2. B — Influencing the level of aggregate demand through taxation and government spending is an objective of fiscal policy. Controlling inflation and interest rates are typical objectives of monetary policy. (LOS 14.b)

Module Quiz 14.2

1. C — The amount of the spending program exactly offsets the amount of the tax increase, leaving the budget unaffected. The multiplier for government spending is greater than the multiplier for a tax increase. Therefore, the balanced budget multiplier is positive. All of the government spending enters the economy as increased expenditure, whereas spending is reduced by only a portion of the tax increase. (LOS 14.c)

2. B — fiscal multiplier = \(1 / [1 - \text{MPC}(1 - T)] = 1 / [1 - 0.80(1 - 0.3)] = 2.27\); change in government spending = −$50 million; change in aggregate demand = −(50 × 2.27) = −$113.64 million. (LOS 14.c)

3. B — Crowding out refers to the possibility that government borrowing causes interest rates to increase and private investment to decrease. If government debt is financing the growth of productive capital, this should increase future economic growth and tax receipts to repay the debt. Ricardian equivalence is the theory that if government debt increases, private citizens will increase savings in anticipation of higher future taxes, and it is an argument against being concerned about the size of government debt and budget deficits. (LOS 14.d)

4. C — More frequent and current economic data would make it easier for authorities to monitor the economy and to recognize problems. The reduction in the time between economic reports should reduce the recognition lag. (LOS 14.d)

5. B — Increases in government spending and decreases in taxes are expansionary fiscal policy. Decreases in spending and increases in taxes are contractionary fiscal policy. (LOS 14.d)