CHAPTER 9
FISCAL POLICY

 

CHAPTER OVERVIEW

This chapter looks briefly at the legislative mandates given to government to pursue stabilization of the economy; it then explores the tools of government stabilization policy in terms of the aggregate demand-aggregate (AD-AS) model. Next, some fiscal policy measures that automatically adjust government expenditures and tax revenues when the economy moves through the business cycle phases are examined. Finally, problems, criticism, and complications of government’s fiscal policy are addressed.

WHAT’S NEW

While the organizational structure of this chapter remains relatively untouched, the content has been revised significantly.  The graphical analysis of expansionary and contractionary fiscal policy has been revised to reflect the new treatment of the AS curve, as presented in Chapter 8. 
The section on “Supply-Side Fiscal Policy” has been replaced with “Current Thinking on Fiscal Policy,” and offers a more up-to-date perspective.  Discussion of the “political business cycle” has been revised.   The section covering fiscal policy and the price level has been eliminated as other coverage makes it redundant.
There is a new graphical presentation of the crowding-out and net export effects of fiscal policy.
A “Consider This” box on “The ‘Feel Good’ Budget of 2003” has been added.
Tables, figures, and questions have been updated.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to understand:

1. What fiscal policy is and what it is used for.
2. About the economy’s built-in stabilizers.
3. The problems, criticisms, and complications of fiscal policy.

COMMENTS AND TEACHING SUGGESTIONS

1. Because taxes are so newsworthy, fiscal policy is one of the subjects that students usually find very interesting. The chapter provides an excellent opportunity to establish the ties between theory and real‑world applications.
2. Watch for any current federal tax or spending issues that can illustrate the timing, administrative, and political problems with discretionary fiscal policy. Inevitably in an election year there is some stimulus given to the economy by Parliament.
3. The Last Word for the chapter is on the “leading indicators.” This should be of particular interest to future business and economics majors, who may be able to use these predictors in their future careers.

STUDENT STUMBLING BLOCKS

1. The biggest concern is with the magnitude of information in this chapter.  Give students an opportunity to focus on a few concepts at a time rather than assigning the entire chapter at once.
2. Although most students know this, some need to be reminded how Parliament establishes fiscal policy at the federal level. This is particularly important when highlighting the different policy-making process for monetary policy.

LECTURE NOTES

I.          Introduction
A.  One major function of the government is to stabilize the economy (prevent unemployment or inflation).
B.   Stabilization can be achieved in part by manipulating the public budget—government spending and tax collections—to increase output and employment or to reduce inflation.
C.   This chapter will examine a number of topics.
1.   It will look at the legislative mandates given government to pursue stabilization.
2.   It explores the tools of government fiscal stabilization policy using AD-AS model.
3.   Both discretionary and automatic fiscal adjustments are examined.
4.   The problems, criticisms, and complications of fiscal policy are addressed.

1. Fiscal Policy and the AD/AS Model

A.  Discretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Parliament to alter real domestic output and employment, control inflation, and stimulate economic growth.  “Discretionary” means the changes are at the option of the Federal government.
B.   Simplifying assumptions:
1.   Assume initial government purchases don’t depress or stimulate private spending.
2.   Assume fiscal policy affects only demand, not supply, side of the economy.

1. Fiscal policy choices: Expansionary fiscal policy is used to combat a recession (see examples illustrated in Figure 9-1).
2. Expansionary Policy needed: In Figure 9-1, a decline in investment has decreased AD from AD1 to AD2 so real GDP has fallen and also employment declined.  Possible fiscal policy solutions follow:

      a.   An increase in government spending (shifts AD to right by more than change in G),
b.   A decrease in taxes (AD shifts to right by a multiple of the change in consumption).

1. A combination of increased spending and reduced taxes.
2. If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.

      2.   Contractionary fiscal policy needed: When demand‑pull inflation occurs as illustrated by a shift from AD2 to AD3. 
D.  Policy options:  G or T?
1.   Economists tend to favour higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure.
2.   Others tend to favour lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.
III.       Built-In Stability
A.  Built‑in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP (recall that taxes reduce incomes and therefore, spending).  It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary.  Figure 9-3 illustrates how the built-in stability system behaves.
1.   Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls.
2.   Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP.
B.   The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP:  The more progressive the tax system, the greater the economy’s built‑in stability.  In Figure 9-3 line T is steepest with a progressive tax system.

1.  Automatic stability reduces instability, but does not correct economic instability.

IV.       Evaluating Fiscal Policy

1. A cyclically adjusted budget (full‑employment budget) in Year 1 is illustrated in Figure
   9-4(a) because budget revenues equal expenditures when full-employment exists at GDP1.
2. At GDP2 there is unemployment and assume no discretionary government action, so lines G and T remain as shown.
3. Because of built‑in stability, the actual budget deficit will rise with decline of GDP; therefore, actual budget varies with GDP.
4. The government is not engaging in expansionary policy since budget is balanced at F.E. output.
5. The cyclically adjusted budget measures what the federal budget deficit or surplus would be with existing taxes and government spending if the economy is at full employment.
6. Actual budget deficit or surplus may differ greatly from full‑employment budget deficit or surplus estimates.

            C.   In Figure 9-4b, the government reduced tax rates from T1 to T2, now there is a F.E. deficit.

1. Structural deficits occur when there is a deficit in the full‑employment budget as well as the actual budget.
2. This is expansionary policy because true expansionary policy occurs when the full‑employment budget has a deficit.

            D. If the F.E. deficit of zero was followed by a F.E. budget surplus, fiscal policy is contractionary.
E.   Global Perspectives 9-1 gives a fiscal policy snapshot for selected countries.
V.        Problems, Criticisms and Complications
A.  Problems of timing
1.   Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence.
2.   Administrative lag is the difficulty in changing policy once the problem has been recognized.
3.   Operational lag is the time elapsed between change in policy and its impact on the economy.
B.   Political considerations:  Government has other goals besides economic stability, and these may conflict with stabilization policy.

1. A political business cycle may destabilize the economy:  Election years have been characterized by more expansionary policies regardless of economic conditions.

a.   political business cycle?
2.   Provincial and local finance policies may offset federal stabilization policies.  They are often pro-cyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending making the recession possibly worse.  In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus.
3.   The crowding‑out effect may be caused by fiscal policy.
a.   “Crowding‑out” may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy.  (See Figure 9-5)
b.   Some economists argue that little crowding out will occur during a recession.
c.   Economists agree that government deficits should not occur at F.E., it is also argued that monetary authorities could counteract the crowding‑out by increasing the money supply to accommodate the expansionary fiscal policy.

1. With an upward sloping AS curve, some portion of the potential impact of an expansionary fiscal policy on real output may be dissipated in the form of inflation.

VI.       Fiscal Policy in an Open Economy (See Table 9-2)
A.  Shocks or changes from abroad will cause changes in net exports which can shift aggregate demand leftward or rightward.
B.   The net export effect reduces effectiveness of fiscal policy:  For example, expansionary fiscal policy may affect interest rates, which can cause the dollar to appreciate and exports to decline (or rise).
VII.     LAST WORD:  The Leading Indicators
A.  This index comprises 10 variables that have indicated forthcoming changes in real GDP in the past.
B.   The variables are the foundation of this index consisting of a weighted average of ten economic measurements.  A rise in the index predicts a rise in the GDP; a fall predicts declining GDP.
C.   None of these factors alone is sufficient to predict changes in GDP, but the composite index has correctly predicted business fluctuations many times (although not perfectly).  The index is a useful signal, but not totally reliable.

ANSWERS TO END-OF-CHAPTER QUESTIONS

9-1       (Key Question) What are government’s fiscal policy options for an inflationary gap caused by demand-pull inflation? Use the aggregate demand–aggregate supply model to show the impact of these policies on the price level. Which of these fiscal policy options do you think a person who wants to preserve the size of the government might favour? A person who thinks the public sector is too large?
Reduce government spending, increase taxes, or some combination of both. See Figure 9-2. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person who thinks the public sector is too large  might favour cuts in government spending, since this would reduce the size of government. A person who wants to preserve the size of the government might favour a tax hike; it would preserve government spending programs.
9-2       (For students assigned Chapters 7) Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary gap or an inflationary gap (Figure 7-8). Use the concept of the balanced budget multiplier to explain how equal increases in G and T could eliminate a recessionary gap and how equal decreases in G and T could eliminate an inflationary gap.
A recessionary gap could be eliminated by increasing government spending and/or decreasing personal taxes. Both of these policies have the effect of raising aggregate demand and shifting the aggregate expenditures schedule upward toward full employment GDP.
An inflationary gap could be eliminated by pursuing the opposite policies: either decreasing government spending or raising taxes, or both. This would reduce aggregate expenditures and would shift actual spending downward toward the full employment level of real GDP.
Because the balanced budget multiplier essentially multiplies any change in government spending by a factor of 1, an increase in government spending and taxes would still have a positive effect on aggregate expenditures, increasing them by the amount of the initial increase in G. If G were large enough, the recessionary gap could be eliminated. Likewise, a balanced decrease in G and T could eliminate an inflationary gap, because the decline in aggregate expenditures would be equal to G. If the decrease in G were large enough to bring aggregate expenditures to the level of full employment GDP, then the inflationary gap would be eliminated.
9-3       Designate each statement true or false and justify your answer.
a.   Expansionary fiscal policy during a recession will have a greater positive effect on real GDP if government borrows the money to finance the budget deficit than if it creates new money to finance the deficit.
b.   Contractionary fiscal policy  will be more effective if government allows the budget surplus to remain idle  rather than using the surplus to pay off some of its past debt.
(a)  The statement is false. The truth is the opposite because when government creates new money during a depression, there is little danger of inflation and all of the new expenditures will be felt through increased aggregate demand as government’s net spending increases. If the government finances its deficit by borrowing, there is danger that this will crowd out some private borrowing and investment spending. The resulting reduction in private spending offsets the expansionary effect of the fiscal deficit.
(b)  The statement is true. When the government allows the budget surplus to remain idle, these funds are removed from the spending flow. If the government used the surplus to pay off some of its past debt, money is returned to the private sector and at least a portion of it will be pumped into the economy in new expenditures. These expenditures will offset the contractionary effect of the budget surplus.
9-4       Explain how built-in (or automatic) stabilizers work. What are the differences between a proportional, progressive, and regressive tax system as they relate to an economy’s built-in stability?
In a phrase, “net tax revenues vary directly with GDP.” When GDP is rising so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments such as unemployment compensation, and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP.
A progressive tax system would have the most stabilizing effect of the three tax systems, and the regressive tax would have the least built-in stability. This follows from the previous paragraph. A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or a regressive tax. The latter rate would rise more slowly than the rate of increase in GDP, with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, but it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax, which falls, but more slowly than the progressive tax, as incomes decline.
9-5       (Key Question) Define the “cyclically adjusted budget” and explain its significance. How does it differ from the “actual budget”? What is the difference between a structural deficit and a cyclical deficit? Suppose the economy depicted in Figure 9-4 is operating at its full employment, non-inflationary level of real output, GDPf. What is the size of its structural deficit? Its cyclical deficit? Should government raise taxes or reduce government spending to eliminate this structural deficit? What are the risks of so doing?
The cyclically adjusted budget is a budget that indicates the amount the federal deficit or surplus would be if the economy operated at full employment throughout the year (whether or not it did). This budget is a useful measure of fiscal policy. An increase in a full employment deficit (or a decrease in a full employment surplus) indicates that fiscal policy is expansionary. A decrease in a full employment deficit (or an increase in a full employment surplus) means that fiscal policy is contractionary. The actual budget simply compares G and T for the year. A structural deficit is another name for a full employment deficit. A cyclical deficit is the difference between G and T caused by tax revenues being below those which are collected when the economy is at full employment.
At GDPf, the structural deficit is ab and the cyclical deficit is zero. Government should raise T or reduce G to eliminate this deficit, but it may want to take this action over several years to avoid pushing the economy into recession.
9-6       Suppose the actual budget deficit increased significantly, but the cyclically adjusted budget deficit remained relatively constant. What would explain this fact?
The explanation must be that the economy entered a recessionary phase and for that reason the deficit is greater than it would have been in a full employment economic situation. During a recession, tax revenues are lower than they would be at full employment and government expenditures for entitlement programs rise more than they would at full employment. Therefore, the actual deficit is greater than the full employment budget deficit.
9-7       (Key Question) Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the notion of a political business cycle. What is the crowding out effect and why is it relevant to fiscal policy? In what respect is the net export effect similar to the crowding‑out effect? Do you think people increase their saving in anticipation of the future higher taxes they believe will follow government’s use of expansionary fiscal policy?
It takes time to ascertain the direction in which the economy is moving (recognition lag); to get a fiscal policy enacted into law (administrative lag); and for the policy to have its full effect on the economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand-pull inflation.
A political business cycle is the concept that politicians are more interested in re-election than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters, even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view the political process creates economic instability.
The crowding out effect is the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending, financed by borrowing. The increase in G was designed to increase AD but the resulting increase in interest rates may decrease I. Thus the impact of the expansionary fiscal policy may be reduced.
The net export effect also arises from the higher interest rates accompanying expansionary fiscal policy. The higher interest rates make Canadian bonds more attractive to foreign buyers. The inflow of foreign currency to buy dollars to purchase the bonds drives up the international value of the dollar, making imports less expensive for Canada, and Canadian exports more expensive for people abroad. Net exports from Canada decline, and like the crowding out effect, diminish the expansionary fiscal policy.
9-8       In view of your answers to question 7, explain the following statement: “While fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to ‘fine-tune’ the economy to the full employment, non-inflationary level of real GDP and keep the economy there indefinitely.”
While fiscal policy is useful in combating the extremes of severe recession with its built-in “safety nets” and stabilization tools, and while the built-in stabilizers can also dampen spending during inflationary periods, it is undoubtedly not possible to keep the economy at its full employment, non-inflationary level of real GDP indefinitely. There is the problem of timing. Each period is different, and the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation. Fiscal policy operates in a political environment in which the unpopularity of higher taxes and specific cuts in spending may dictate that the most appropriate economic policies are ignored for political reasons. Finally, there are offsetting decisions that may be made at any time in the private and/or international sectors. For example, efforts to revive the economy with more government spending could result in reduced private investment or lower net export levels.
Even if it were possible to do any fine tuning to get the economy to its ideal level in the first place, it would be virtually impossible to design a continuing fiscal policy that would keep it there, for all of the reasons mentioned above.
9-9       Suppose that government engages in deficit spending to push the economy away from recession and that this spending is directed toward new “public capital” such as roads, bridges, dams, harbours, office parks, and industrial sites. How might this spending increase the expected rate of return on some types of potential private investment projects? What are the implications for the crowding-out effect?
Government spending that is directed toward the improvement of the infrastructure (roads, bridges, dams, and harbours) provides additional “public capital” that increases the “production possibilities” of the nation. Private business firms benefit from these improvements through more convenient and reliable transportation systems and other amenities that lower production costs and make their business locations more desirable. Business firms that benefit from these public projects are, in effect, being subsidized by the government spending. These firms are likely to find that the publicly funded improvements increase the expected rate of return on their own investment projects.
Some economists argue that little crowding out will occur if deficit spending is carried out during a recession. In addition, if the increased government spending improves business profit expectations, as suggested above, private investment need not fall, even though interest rates rise.
9-10     Use Figure 9‑4(a) to explain why a deliberate increase in the full-employment budget (resulting from the tax cut) will reduce the size of the actual deficit if the fiscal policy succeeds in pushing the economy to its full-employment output of GDP3. 
To the extent the deficit increase is successful in expanding the economy, equilibrium GDP will be to the right of its original position in Figure 9‑4.  The higher GDP means greater income and employment, which should raise total tax revenues despite lower rates and automatically reduce government spending on many social programs as fewer recipients qualify for support.  The expansionary policy could have a beneficial effect on both the economy and the actual budget deficit
9-11  Advanced analysis (For students assigned Chapters 7): Assume that, without taxes, the                  consumption schedule for an economy is as shown below:

a.   Graph this consumption schedule and determine the size of the MPC.
b.   Assume a lump sum (regressive) tax is imposed such that the government collects $10 billion in taxes at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with that of the pretax consumption schedule.
c.   Now suppose a proportional tax system with a 10 percent tax rate is imposed instead of the regressive system. Calculate the new consumption schedule, graph it, and note the MPC and the multiplier.
d.   Finally, impose a progressive tax system such that the tax rate is zero percent when GDP is $100, 5 percent at $200, 10 percent at $300, 15 percent at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC and the multiplier.
e.   Explain why the proportional and progressive tax systems contribute to greater economic stability, while the regressive system does not. Demonstrate using a graph similar to Figure 9-3.
(a) 
(b)  

            The MPC is 0.8 [= ($192 - $112) billion/(200 - $100) billion = 80 / 100], as before the tax increase. And the spending multiplier remains 5 [1/(1 – 0.8 = 1 / 0.2)].

(c)

      The MPC is 0.72 [= ($184 - $112) billion /($200 - $100) billion = 72 / 100].
And the spending multiplier is now 3.57 [= 1/(1 – .072) = 1 / 0.28)].
(d)

(e)  The MPC decreases as shown in the right‑hand column above. Proportional and (especially) progressive tax systems reduce the size of the MPC and, therefore, the size of the multiplier. A lump sum tax does not alter the MPC or the multiplier.
NOTE:   For instructors who assign the graphs, the following would be true. For each graph (a) through (d), plot the consumption schedule against the GDP. Graph (a) will have a slope of .8 and will cross the 45 degree line at C = GDP = 200. Graph (b) is parallel to (a) but $10 billion below it and will cross the 45 degree line at C = GDP = 150, indicating the multiplier of 5 ($10 billion loss in income leads to $50 billion drop in equilibrium GDP). Graph (c) will not be as steep as (a) or (b), with a slope of .72 and equilibrium between GDP = 200 and GDP = 300 on the diagram. Graph (d) has a decreasing slope so it will not be a straight line. Equilibrium is just beyond GDP = 200. The multiplier is illustrated by noting the change in equilibrium GDP if any curve were to be shifted by a given amount. The multiplier is the ratio of change in equilibrium GDP to the vertical shift.
9-12     (The Last Word) What is the composite index of leading economic indicators, and how does it relate to discretionary fiscal policy?
The composite index of leading indicators is a monthly index of a group of variables that in the past has provided advance notice of changes in GDP. Changes in the index provide a clue to the future direction of the economy and may shorten the length of the “recognition lag” associated with the implementation of discretionary fiscal policy.

Consider This
Go to the Department of Finance home page, at http://www.fin.gc.ca/fin-eng.html, and click “Budget Info” to get information on the latest budget. Did this budget lead to a federal government deficit? Is this deficit or surplus large or small when expressed as a percentage of GDP?
Each year the answer will be different. What must be stressed is that the budget surplus or deficit should be expressed as a percentage of GDP to determine whether it is “large” or “small”.