SAYRE | MORRIS Seventh Edition

Fiscal Policy

CHAPTER 7

7-1© 2012 McGraw-Hill Ryerson Limited

Fiscal Policy • Government’s approach toward its own spending

and taxation

• Minister of finance brings down annual budget in Parliament each spring

• Contains estimates of government’s revenues and expenditures

7-2© 2012 McGraw-Hill Ryerson Limited

LO1

Fiscal Policy

Table 7.1

Federal Government Budget Year Ending March 2010

6-3© 2012 McGraw-Hill Ryerson Limited

LO1

REVENUES Personal income taxes 103.9Corporate and other income taxes 36.0E.I. premiums 16.8GST and excise and energy taxes 40.6Nontax revenues 21.6Total Revenues 218.6OUTLAYS Transfers to persons 68.6Spending grants to other levels of govt 57.0Public debt charges 29.4Direct program spending 119.2Total Outlays 274.2Projected Budget Plan Deficit 55.6Source: Data derived by authors from information found in Department of Finance; Annual Report to the Government 2009-2010. Reproduced with the permission of the Minister of Public Works and Government Services, 2010.

Net Tax Revenue • total tax revenue received by government less

transfer payments

Budget Balance • the difference between net tax revenues and

government spending

7-4© 2012 McGraw-Hill Ryerson Limited

LO1

Fiscal Policy

NTR = tax revenue transfer payments

Budget Balance = NTR - G

Budget Surplus • net tax revenue in excess of government spending on

goods and services

Budget Deficit • government spending on goods and services in

excess of net tax revenues

7-5© 2012 McGraw-Hill Ryerson Limited

LO1

Fiscal Policy

National Debt • the sum of the federal government’s budget deficits

less its surpluses

Balanced Budget • the equality of net tax revenues and government

spending on goods and services

7-6© 2012 McGraw-Hill Ryerson Limited

LO1

Fiscal Policy

Table 7.2

Net National Debt (current $ billion)

6-7© 2012 McGraw-Hill Ryerson Limited

LO1

Year Budget Surplus Budget Deficit Net National Debt

1940 — 0.1 3.3 1963 — 0.8 15.7 1973 — 1.9 24.0 1983 — 29.0 136.7 1993 — 39.0 449.0 1997 — 8.7 562.9 1998 3.0 — 559.9 1999 5.8 — 554.1 2000 14.3 — 539.9 2001 19.9 — 520.0 2002 8.0 — 511.9 2003 6.6 — 505.3 2004 9.1 — 496.2 2005 1.5 — 494.7 2006 13.2 — 481.5 2007 13.8 — 467.3 2008 9.6 — 457.62009 — −5.8 463.72010 — −55.6 519.1

Department of Finance: Fiscal Reference tables October 2010.

© 2012 McGraw-Hill Ryerson Limited 7- 8

LO1

© 2012 McGraw-Hill Ryerson Limited 7- 9

LO1

The government budget is affected by:

• the level of the GDP

• A change in the amount of government spending

• A change in the amount of government revenue (taxation)

7-10© 2012 McGraw-Hill Ryerson Limited

LO1

Fiscal Policy

John Maynard Keynes: • Developed model in response to the depression

• Based on aggregate expenditures: AE = C + I + G + Xn

• Believed depression was caused by decreased aggregate expenditures

• Argued for increased government expenditures to increase employment and incomes

• Increased spending financed through borrowing

7-11© 2012 McGraw-Hill Ryerson Limited

LO2

Countercyclical Fiscal Policy

Counter-Cyclical Fiscal Policy

Chapter 11-12

Dealing with a recessionary gap: - raise G and/or lower T- total spending increases to AD2 - shifts economy back to potential GDP

Dealing with a recessionary gap: - raise G and/or lower T- total spending increases to AD2 - shifts economy back to potential GDP

YFEY1

P

Real Y

AD1

AD2

AS1

Potential GDP

G

Recessionary gap

LO2

Counter-Cyclical Fiscal Policy

Chapter 11-13

YFE Y1

P

Real Y

AD2

AD1

AS1

Potential GDP

G

Inflationary gap

Dealing with an inflationary gap:

- lower G and/or raise T- total spending decreases to AD2 - shifts economy back to potential GDP

Dealing with an inflationary gap:

- lower G and/or raise T- total spending decreases to AD2 - shifts economy back to potential GDP

LO2

Summary:

• When there is a recessionary gap, governments should spend and tax in a way that increases aggregate demand.

• When there is an inflationary gap, governments should spend and tax in a way that reduces aggregate demand.

7-14© 2012 McGraw-Hill Ryerson Limited

LO2

Countercyclical Fiscal Policy

Shortcomings:

• it is subject to serious time lags

• it has an inflationary bias

• it can cause serious budget deficits

7-15© 2012 McGraw-Hill Ryerson Limited

LO2

Countercyclical Fiscal Policy

• the government budget is balanced in each fiscal period

• addresses the shortcomings of a countercyclical fiscal policy

• relies on automatic stabilizers (tax laws and spending programs that cut back spending during a boom and increase spending in a slowdown)

• based on belief that economy will return to full employment on its own

7-16© 2012 McGraw-Hill Ryerson Limited

LO3

Balanced Budget Fiscal Policy

Balanced Budget Fiscal Policy

Chapter 11-17

Recessionary gap: - eventually wages will be forced down -AS increases, returning economy to YFE - also decreases price level

Recessionary gap: - eventually wages will be forced down -AS increases, returning economy to YFE - also decreases price level

YFEY1

P

Real Y

AD

AS1

Potential GDP

Wages

Recessionary gap

LO2

AS2

AS would increase because we know that when a productive resource decreases (wages), supply increases.

Shortcomings:

• Procyclical: pushing the economy further in the same direction it is going

• balanced budget is procyclical in a recessionary gap, because low tax revenues create deficits

• may be procyclical in an inflationary gap, if it is accompanied by a budget surplus

7-18© 2012 McGraw-Hill Ryerson Limited

LO3

Balanced Budget Fiscal Policy

• the use of countercyclical fiscal policy to balance the budget over the life of the business cycle

• no guarantee that size and length of recessionary gap will be exactly offset by the size and length of the inflationary gap

• most governments find it easier to increase spending in bad times than to decrease it in good times

7-19© 2012 McGraw-Hill Ryerson Limited

LO4

Cyclically Balanced Budget Fiscal Policy

• government borrows by issuing bonds

• debt held by individuals, corporations, and financial institutions

• interest payments represent redistribution of wealth from all taxpayers to relatively wealthy bondholders

7-20© 2012 McGraw-Hill Ryerson Limited

LO5

Fiscal Policy and National Debt

© 2012 McGraw-Hill Ryerson Limited 7- 21

LO5

• debt increased significantly to finance WWII

• debt increased again since 1970s

• increase in income-support programs

• high interest rates in 1970s and 1990s

• since 1995, Canada’s debt fell to lowest of G8

7-22© 2012 McGraw-Hill Ryerson Limited

LO5

Fiscal Policy and National Debt

Problems with High Deficits / Debt:

• the interest payments that must be paid on the foreign-held debt

• the income redistribution effects of large interest payments

• the reduced ability of government to meet the needs of its citizens

• the possible increased power grabbing and wastefulness of government

7-23© 2012 McGraw-Hill Ryerson Limited

LO5

Fiscal Policy and National Debt

© 2012 McGraw-Hill Ryerson Limited 7- 24