2.4. Fiscal Policy

Fiscal Policy can:• Boost the level of economic activity if there is a shortage of demand, which

is causing a deflationary gap. In this case, it is called reflationary policy.• Reduce the level of economic activity if too much demand in the economy is

causing an inflationary gap. In this case, a deflationary policy is appropriate.• Be a supply-side policy, used to improve incentives, e.g. through income

tax cuts, or to improve the quality of resources, such as increased government expenditure on health and education and subsidies to key areas.

Sources of government revenue

In order to provide all the goods and services governments are expected to provide they need funding. Whether this is directly providing health, education, security (eg police, army, fire department etc) or subsidising merit goods (solar energy, pharmaceuticals, research and development, The Arts etc) they need to raise (collect) revenue.

TaxesTax systems include direct taxes (income tax, profit tax, capital gains etc) and indirect taxes (sales taxes - VAT, GST; excise taxes -  tobacco, alcohol, import)Sale of Goods and Services

When governments own and run enterpises (usually utilities) they charge for the goods and services they sell (eg electricity, gas, clean water) and there are charges for non-utilities such as museums, national parks, toll roads etc)

The government budget is a statement that sets out all revenue streams coming into the government treasury departments and all the expenditures made by the government (or public sector, which includes municiple and local government as well as national government).

There can be a

• Budget deficit (expansionary on the economy because spending - injection- is greater than tax revenue - withdrawal).

• Budget surplus (contractionary on the economy because spending - injection- is less than tax revenue - withdrawal)

• Budget balance (no net effect on the economy because spending - injection- is equal to tax revenue - withdrawal)

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The UK government budget

Sources of government income

Source: From 2011 UK Budget http://www.hm-treasury.gov.uk/d/junebudget_complete.pdf

Types of government expenditureSo government spending or government expenditure is often divided into three main types:

• Current Expenditures or Government final consumption expenditure on goods and services for current use to directly satisfy individual or collective needs of the members of the community. Capital Expenditure or Gross

•  Capital Expenditures or fixed capital formation (or government investment) - government spending on goods and services intended to create future benefits, such as infrastructure investment in transport (roads, rail airports), health (water collection and distribution, sewage systems, communication (telephone, radio and tv) and research spending (defence, space, genetics).

• Transfer payments - spending that does not involve transactions of goods and services, but instead represent transfers of money, such as social security payments, pensions and unemployment benefit.

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The budget outcome

Distinguish between a budget deficit, a budget surplus and a balanced budget.• Budget deficit exists where government income from taxation is less than

government spending: R<T• Budget surplus exists where government income from taxation exceeds

government spending: R>T• Balanced budget exists where government income from taxation equals

government spending: R=T

Fiscal stance refers to the position the government is taking with regard to operating a budget deficit, budget surplus or a balanced budget. Whilst you may think that it would be common sense for a government to always run a budget surplus or a balanced budget, there may be very good reasons for it to deliberately choose to operate a budget deficit (Keynesian expansionary policy)Syllabus:

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Explain the relationship between budget deficits/ surpluses and the public (government) debt.

National debt refers to the total amount that the government has borrowed over time as a consequence of operating budget deficits.

• This is a great site to show you the extent of the USA National Debt Watch it increasing by the second.

• How much is Brazil's national debt?

Clearly, if there is a budget deficit the national debt is increased by that amount (because extra spending must be financed by borrowing if it does not come from tax revenue).

A budget surplus reduces the national debt• Public sector borrowing requirement (PSBR) is where total government

income (tax revenue and income from public corporations) is less that government spending. It is largely made up of the budget deficit. In such cases, the government has to borrow money to finance the short fall. It can do this by selling national savings certificates and securities such as gilts or treasury bills and bonds.

• Public sector debt repayment is where total government income (tax revenue and income from public corporations) is greater than total government spending. In such cases, the government can repay some its previously accumulated national debt.

Task 1: What does the data say?• Using the Censtadt website http://www.censtatd.gov.hk/home/index.jsp• Record:

Total government revenueTotal government expenditure for Hong Kong for the most recent years

where data is available.

Put the data into a spreadsheeta) Plot the two data sets on the same graph over time.b) Describe the state of the budget for each of the years.c) Describe changes in the budget over the years i.e. moves from surplus to

deficit or vice versa?d) In the event of a budget deficit, identify how this was financed.

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Nature of Taxation

In Economics there are two main types of taxes: direct taxes and indirect taxes.

Direct Taxes: are taken directly from a person or firm. The tax is paid directly to the government – no intermediary is involved in collecting it on behalf of the government. E.g. income tax; corporation tax; capital gains tax and inheritance tax.

Indirect Taxes: are taxes taken from individuals or firms when they consume goods and services that have been taxed. They are collected by a third party on behalf of the government. E.g. sales taxes, tariffs and excise duties

Progressive TaxationA tax is progressive when it takes a greater percentage of income or wealth from the high income or wealthier groups than it does from the low income, poorer groups in society. E.g. Portugal’s system of Income Tax.

Average rate of tax is the average rate of tax paid on taxable income.

Marginal rate of tax is the tax rate that a worker faces when it earns an additional €uro

Example

Assume that there is a tax-free allowance of €4000Tax is levied as follows:

First €4000 of taxable income is taxed at 25% Next €12000 of taxable income is taxed at 50% Any income above that is taxed at 80%

Income Taxable Income

Tax rate Tax Payable

Average Tax Rate

Marginal Tax Rate

4000

8000

20000

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Proportional Taxation

A tax is proportional when all tax payers pay the same percentage of their income or wealth. E.g. Corporation Tax – tax on corporate profits.

Example

Profits are taxed at 40%

Income Taxable Income

Tax rate Tax Payable

Average Tax Rate

Marginal Tax Rate

4000

8000

20000

Regressive taxation

Taxes are regressive when they take a greater percentage of income or wealth from the poor/low-income sectors of society. E.g. taxes such as excise duty on tobacco, beer and petrol act regressively since the amount of tax included in the prices of these goods represents a greater % of the incomes of poorer groups.

Example

Tax is levied as follows:

First €4000 of taxable income is taxed at 60% Next €4000 of taxable income is taxed at 30% Next €12000 of taxable income is taxed at 20% Any income above that is taxed at 10%

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Income Taxable Income

Tax rate Tax Payable

Average Tax Rate

Marginal Tax Rate

4000

8000

20000

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Fiscal policy and short-term demand managementExplain how changes in the level of government expenditure and/or taxes can influence the level of aggregate demand in an economy.

Aggregate Demand and BudgetsThe AD curve is shifted by changes in the components of AD (C+I+G+X-M). Therefore the government can attempt to influence the level of Real GDP produced and in turn affect government objectives: inflation, unemployment, economic growth.

Reflationary or expansionary fiscal policy (Shifting AD to the right) Governments may choose to employ reflationary or expansionary fiscal policy in times of recession or a general downturn in economic activity. In this situation, they will use fiscal policy to stimulate the economic activity. They may do this by lowering taxes (withdrawals) in some form or by increasing government expenditure (G - injection).

If they lower indirect taxes then this will lower the prices of the taxed goods and encourage more consumption expenditure (C).

Alternatively, they could lower direct taxes increasing disposable incomes (take-home pay) and encouraging greater consumption (C). Either way the level of demand in the economy should rise and stimulate economic growth.

Reflationary fiscal policies can include:• Cutting the lower, basic or higher rates of tax• Increasing tax-free allowances• Increasing the level of government expenditure

The effect of these policies should be to boost aggregate demand and the equilibrium level of income.

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First, remember a deflationary gap (Keynesian) is when equilibrium (Y) Real GDP  is lower than Full Employment Real GDP (asa shown in the digram on the left). The government may choose to use a reflationary policy to shift AD to the right and bring the economy closer to Full Employment (Yf).

Construct a diagram to show the potential effects of expansionary fiscal policy, outlining the importance of the shape of the aggregate supply curve.

However, reflationary policy may cause demand-pull inflation. Keynesians would argue that reflationary fiscal policy is appropriate where there is spare production capacity (demand deficient unemployment) as they believe that the economy can settle at any equilibrium level of output. Their view of reflationary policy can be seen in Figure 2 below.

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Figure 2 Reflationary fiscal policy - Keynesian analysis

Reflationary policy shifts AD to the right but the closer to full employment (vertical section of AD) the more the effect will be on the price level rather than on Real Output (Real GDP).

For Keynesians, any increase in AD on the horizontal section of the AS curve will not be inflationary because there will be spare resources firms can use to increase output without increasing costs of production. Prices will only increase when the economy approaches full employment and can only be inflationary as the AS curve becomes vertical.

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Deflationary fiscal policy (Shifting AD to the left)Syllabus: Explain the mechanism through which contractionary fiscal policy can help an economy close an inflationary gap.

Deflationary fiscal policy is likely to be most appropriate in times of economic boom (remember business cycle).

If the economy is growing at above its capacity (short run Peak or Boom), this is likely to cause inflation and balance of payments problems.

Figure 3: Inflationary Gap (Yf to Y1)

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To slow the growth of the economy, the government could increase taxes in some form and/or reduce government expenditure. Either of these should reduce the level of demand in the economy and, therefore, the level of economic growth. The government may increase indirect taxes, which will result in higher prices for goods and services if firms maintain their profit margins. This should deter consumers from purchasing the same quantity of goods and services. Alternatively, the government may increase direct taxes, which will leave people with less money in their pockets and discourage spending.

Syllabus: Construct a diagram to show the potential effects of contractionary fiscal policy, outlining the importance of the shape of the aggregate supply curve.

Figure 4 Closing the Inflationary Gap (Yf to Y1)

Deflationary fiscal policies include:• Increasing the lower, basic or higher rates of tax• Reducing the level of personal allowances• Reducing the level of government expenditure

The effect of these policies will be to shift the aggregate demand curve from AD1 to AD2, as in Figure 4 above, to return to Full Employment.

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Impact of automatic stabilisers

"Automatic stabilizers are features of the tax and transfer systems, that tend by their design to offset fluctuations in economic activity without direct intervention by policymakers. When incomes are high, tax liabilities rise and eligibility for government benefits falls, without any change in the tax code or other legislation. Conversely, when incomes slip, tax liabilities drop and more families become eligible for government transfer programs, such as food stamps and unemployment insurance, that help support their income."

Source: http://www.taxpolicycenter.org/briefing-book/background/stimulus/stabilizers.cfm

In section 2.1, you discovered that real GDP fluctuates over time and that these create short term business or trade cycles. Economies move through the following cycle:

• Peak/boom• Downturn/ recession• Trough/depression• Recovery/expansion; leading back to a peak/boom

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Income taxation and transfer payments can act as non-discretionary fiscal policy, in that they automatically have the effect of lessening the business cycle.

During times of expansion, when real GDP is growing, incomes will be increasing. If the country has a progressive tax, such as an income tax, in place an increasing proportion of those incomes will be paid to the government as incomes rise and transfer payments such as unemployment benefit will decrease. This represents a leakage and a reduction in injections from the circular flow of income and is not spent goods and services. The effect of this is to reduce the rate of growth of GDP.

Similarly, during times of recession when real GDP is falling, incomes will fall as unemployment increases. Transfer payments, such as unemployment benefits, will increase and tax revenue will decrease ensuring that consumption does not slow-down in the same proportion as falling employment income. Real GDP, therefore, does not continue to fall at the same rate.

Fiscal dragWe have shown the effect of automatic stabilizers dampening down the business cycle and bringing about certain amount of stability in output, employment and income. However, automatic stabilizers can sometimes cause problems if the economy is in a depression with a great deal of unemployment. The stabilizers can reduce the upward effects of the multiplier as the government tries to kick start a recovery by increasing government spending. Incomes will not increase as rapidly as hoped, because additional taxation causes some of the injections to be leaked from the circular flow of income. Similarly, if governments want to introduce a discretionary deflationary policy to close an inflationary gap, the existence of transfer payments will not enable the desired reduction in consumer spending to happen as fast as the government may want. In both cases, the discretionary policy is being dragged back by the stabilizers, hence the term, 'fiscal drag'.

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Fiscal policy and its impact on potential outputEvaluate the view that fiscal policy can be used to promote long-term economic growth (increases in potential output) indirectly by creating an economic environment that is favourable to private investment, and directly through government spending on physical capital goods and human capital formation, as well as provision of incentives for firms to invest.

Long Term Economic growth is depicted as a shift in LRAS to the right (ie an increase in the production potential of the economy or full employment real GDP)

   Figure 1 Increase in Production Potential (Y1 to Y2) Neoclassical

 

 

Figure 2 Increase in Production Potential (Keynesian)

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Supply-side policies are policies that aim to increase the capacity of the economy to produce. However, it is also possible for fiscal policy to act on the level of supply and government will often use fiscal policy as one of their key supply-side policy tools.

Income tax may have an effect on people's incentives to work. This will be true at most income levels.

If income tax at low-income levels is too high, people may choose to remain unemployed, or not to seek, employment. This is an economically rational decision, because it may be more rewarding to stay on benefits when other expenses of employment, such as transport and child-care, are factored in. This situation is often referred to as a 'poverty trap', because the unemployed cannot improve their financial position.

If income tax on high levels of income is too high, people (Entrepreneurs) may choose not to work so hard or take risks. Ultimately, they could make the choice to leave a particular country if taxes in other countries are significantly lower This 'flight' out a country to seek lower taxes elsewhere is called a 'brain drain', when the process involves large numbers of the most talented and skilled in a population.

Supply-side fiscal policies can include:• Cutting the lower and basic rates of tax to open up the gap between the

earnings in work and the benefits of those who are unemployed, to ensure people have an incentive to work

• Increasing the level of tax-free personal allowances for the same reason• Reducing the top rate of tax to encourage enterprise, risk-taking and the

incentive to work harder1 Government spending on health and education and infrastructure such

as roads and railways.

The intended effects of these supply-side policies are known as 'microeconomic effects' although bear in mind that they may have macroeconomic effects as well.

In a nutshell, free market economists favour using fiscal policy as a means of affecting incentives (Long Run). While Keynesians favour using fiscal policy to directly affect economic activity through Aggregate Demand (Short Run).

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Evaluation of fiscal policy

Evaluate the effectiveness of fiscal policy through consideration of factors including:

• the ability to target sectors of the economy,• the direct impact on aggregate demand,• the effectiveness of promoting economic activity in a recession,• time lags,• political constraints,• crowding out, and• the inability to deal with supply side causes of instability.

The effectiveness of fiscal policy, as a measure to influence aggregate demand and output, is open to much debate.

The argument over using fiscal policy revolves around whether:

• It can be used as a fine tuning mechanism• It can be used to achieve the desired level of national income• It can be used to reduce unemployment without causing overheating and

inflation• The 'right' levels of government spending and taxation be determined• Changes in government spending and taxation can be offset by changes in

other injections and leakages• Time lags between changing policy and the effects are too long for the

desirable results to be estimated or achieved• An increase in aggregate demand will necessarily lead to an increase in

output income and employment• Expansionary fiscal policy will have any undesirable effects, such as

inflation, worsening the balance of payments situation or ' crowding out' private borrowing and investment

Major arguments in favour of fiscal policyIncreasing aggregate demand through changing government spending and taxation will increase output, employment and income, in the short run, working through an expenditure multiplier process.

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Major arguments against fiscal policyFiscal policy - weaknesses

• Time Lags- changes in direct taxes may take considerable time to implement and government spending is often inflexible in a downwards direction; e.g. for political or moral reasons, it is usually difficult to reduce government spending on pensions and benefits and once a capital project such as a motorway has been started, it is difficult, if not impossible, to stop it in mid-stream.

• Conflicts between objectives - fiscal policy designed to achieve one goal may adversely impact on another. For example, reflationary fiscal policy designed to stimulate aggregate demand and reduce unemployment may worsen inflation (N.B. for HL students only, this is explained in greater detail in the extension section on the long run Phillips curve).

• Supply-side economists believe that certain fiscal measures will have a disincentive effect. For example, an increase in income tax may adversely affect the supply of labour; an increase in profits tax may adversely affect the incentives of firms to invest and an increase in welfare benefits may adversely affect incentives to seek employment.

Crowding Out

Many economists argue that the government should aim, as a policy objective, to minimize the level of government borrowing and should not increase its spending if this means borrowing to do so. If the government borrows heavily, it will have to compete for funds with private sector firms, which want to borrow to invest themselves. This competition for funds will push up interest rates. Higher interest rates mean that firms will be less willing to invest and individuals may even be more reluctant to borrow to spend. This process is described as government expenditure 'crowding out' private borrowing. In its most extreme form, an increase in government expenditure will lead to an equivalent fall in consumption and investment (because of the higher interest rates) with the result that aggregate demand does not increase at all.

Economists debate how significant the effect of crowding out is and, as with most things, they rarely agree! (Keynesians generally argue that an increase in government spending, through the multiplier process, will crowd in private consumption and investment).

If the problem is one of unemployment, changes in taxation and particularly government spending may have a significant impact on the level of national income through the increase in aggregate demand that they cause. Fiscal policy

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therefore may be very effective in reducing demand-deficient unemployment. (N.B. For HL students only, the effectiveness of fiscal policy in combating unemployment may be explained through the operation of the multiplier effect. This is dealt with in the HL extension section that follows).

Fiscal policy may also succeed in shifting the LRAS curve to the right, increasing real output and reducing the rate of inflation. This may work via greater government spending on education and training and tax cuts, which improve incentives to work and invest.

As will be seen in Section 2.3, fiscal policy may be used to alter the distribution of income and wealth within an economy. Greater emphasis on direct, progressive taxes and benefits to the less well-off make the distribution more equal. The opposite effect will be achieved through a shift towards indirect, regressive taxes and cuts in benefits for the less well-off.

Section 2 of the course showed how fiscal policy can be used in a selective way, for example, to:

• Increase consumption of merit goods through subsidies and direct government provision

• Decrease consumption of demerit goods and imports through taxation• Increase consumption of public goods

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Questions on Fiscal Policy

1: Explain why in the United States total government (Federal, state and local) spending account for about 30% of GDP, while total government purchases are only about 20% of GDP.

2: Explain how discretionary fiscal policy fights recession and inflation.

3: In each of the following cases, explain whether the fiscal policy is expansionary, contractionary or neutral. (a) The government decreases government purchases (b) The government increases taxes(c) The government increases purchases and taxes by an equal amount.

4: Indicate the change in either the aggregate demand curve or the aggregate supply curve for each of the following:(a) Expansionary fiscal policy (b) Contractionary fiscal policy

5: Explain the relationship between budget deficits and the national debt

6: Explain this statement: ‘The national debt is like taking money out of your left pocket and putting it into your right pocket’

7: Suppose the percentage of national debt owned by foreigners increases sharply. Why would this trend concern you?8: Suppose the government has no national debt and spends US$100 billion while raising only US$50 billion in taxes.(a) What amount of government bonds will the US Treasury issue to finance the deficit?(b) Next year, assume that tax revenues remain at US$50 billion. If the government pays a 10% rate of interest, add the debt-servicing interest payment to the government’s $100 billion expenditure for goods and services the second year.(c) For the second year, compute the deficit, the amount of new debt issued, and the new national debt.

9: Suppose you are an economic policy adviser to the Hong Kong Chief Executive and he or she asks for your recommendation to eliminate the budget deficit. What would you recommend?

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10: Explain how individuals’ behaviour is affected by the following features of the US taxation code (many of the features are also part of the HK tax code)

a) Contributions to charity are tax deductible b) Sales of beer are taxedc) Interest that a homeowner pays on a mortgage is tax deductible d) Realised capital gains are taxed but accrued gains are not (when someone

owns a share/stock/equity that rises in value, she has an accrued capital gain. If she sells the share/stock/equity, she has a realised gain

11: What is the difference between the marginal tax rate and an average tax rate?

12: Ms. Jones has a taxable income of US$30000, and she must pay tax of US$3000. Mr. Smith has a taxable income of US$60000. How much tax must Mr. Smith pay for the tax system to be:(a) Progressive(b) Regressive(c) Proportional

13: Complete the following table, which describes the sales tax paid by individuals at various income levels. Indicate whether the tax is progressive, proportional or regressive.

Income (HK$) Total Spending Sales tax paid Sales tax paid as a % of income

100000 100000 10000500000 350000 350001000000 600000 6000010000000 4000000 400000

14: Any income tax schedule embodies two types of tax rates – average tax rates and marginal tax rates.

Proportional Tax

Regressive Tax

Progressive Tax

Income Amount of Tax

Percent of Tax

Amount of Tax

Percent of Tax

Amount of Tax

Percent of Tax

$50000 $12500 25% $15000 30% $10000 20%$100000 $25000 25% $25000 25% $25000 25%$200000 $50000 25% $40000 20% $60000 30%

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(a)The average tax rate is defined as total taxes paid divided by income. For the proportional tax system presented above, what are the average tax rates for people earning: $50000, $100000 and $200000? What are the corresponding average tax rates in the regressive and progressive tax systems?

(b) The marginal tax rate is defined as the extra taxes paid on additional income divided by the increase in income. Calculate the marginal tax rate for the proportional tax system as income rises from $50000 to $100000, and from $100000 to $200000. Calculate the marginal tax rates for the regressive and progressive tax systems?

(c)Describe the relationship between average tax rates and the marginal tax rates for each of these three systems. In general, which rate is relevant for someone deciding whether to accept a job that pays slightly more than her current job?

15: Suppose that the HK government raises its sales tax from 5% to 6%. The finance minister forecasts a 20% increase in sales tax revenue. Is this plausible? Explain.

16: The Tax Reform Act of 1986 (US) eliminated the deductibility of interest payments on consumer debt (mostly credit cards and auto loans) but maintained the deductibility of interest payments on mortgages and home equity loans. What do you think happened to the relative amounts of borrowing through consumer debt and home equity debt?

17: What is the efficiency justification for taxing consumption rather than income? If HK were to adopt a consumption tax, like some Caribbean countries, do you think it would make the HK Tax System more or less progressive? Explain.

18: If a salesperson takes a client to lunch, part of the lunch is a deductible business expense for his company. Some members of the US Congress have argued that this feature of the tax code benefits relatively wealthy businesspeople and should be eliminated. Yet their arguments have been met with greater opposition from eating and drinking establishments than from companies themselves. Explain.

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