Chapter 29: Fiscal Policy
Chapter 29: Fiscal Policy ECON 1010 Textbook Notes •
The federal budget is an annual statement of the outlays and revenues of the government of Canada together with the laws and regulation that approve and support those outlays and revenues.
•
The federal budget pursues the government’s fiscal policy: the use of the federal budget to achieve macroeconomic objectives such as full employment, sustained long-term economic growth and price level stability.
•
Budget Making o Federal government and Parliament make fiscal policy o Discussions between Minister of finance and department of finance start the process o After all consultations, the projections made by the dept of finance, the minster develops and set of proposals which are eventually compiled as a budget to be debated in parliament
•
Highlights of 2011 Budget o Revenues
Federal government’s receipts
Come from our sources: •
Personal Income Taxes o Largest source o Paid by individuals on their income
•
Corporate Income Taxes o Smallest source of revenues o Paid by companies on their profit
•
Indirect and other taxes o Second biggest source o Include taxes like gas tax, HST
•
Investment income
o Income earned from government enterprises and investments o Outlays
Payments made by the government.
Categorized in three categories: •
Transfer payments o Largest outlay, by a huge margin o Payment to individuals, business, other governments, rest of world o Includes social welfare, subsidies, aid to developing countries
•
Expenditures on goods and services o Expenditures on final goods and services such as phones for parliament, government cars
•
Debt interest o Interest on government debt o Depends on year, sometimes exceeds other categories
o Budget balance
•
Revenues – Outlays
If revenues > outlays, budget surplus
If revenues < outlays, budget deficit
The Budget in Historical Perspective o The government has historically rarely been in surplus o Revenues are usually between 15 and 20% of GDP, while expenses are between 15 and 25% of GDP
•
Revenues: o Main sources of fluctuations are in personal income taxes o Changes in policy impact the amount of revenue coming in from income taxes
•
Outlays:
o Main source of change is in transfer payments to provincial governments o Especially high in times of crisis e.g. Alberta drought •
Deficit and Debt: o Government borrows to finance it deficit; total amount of borrowing is government debt o A persistent deficit leads to an increase in debt interest because of an increasing amount of debt incurred, the opposite also applies o Also applies to times of war where debt can increase 100% of GDP
•
Debt and Capital: o When individuals incur debts, they do so to buy capital or major assets o The government is similar in this regard o Some debt is incurred to continue investment; infrastructure, healthcare, public education yield a social rate of return far exceeding the interest rate paid by the government o Government debt > value of public capital stock, therefore some government debt was used to finance public expenditure but not all
•
Supply-side Effects of Fiscal Policy: o Economists on this side of theory believe effects of taxes to be large o (Pre-Tax) Full Employment and Potential GDP:
At full employment, real wage rate adjusts to make quantity of labour demand equal to quantity of labour supplied; without taxes
The labour equilibrium amount occurs at potential GDP, therefore real GDP equals potential GDP
o Effects of Income Tax
Tax on labour incoeme influences potential GDP and aggregate supply by changing the full employment quantit of labour
Income tax weakens incentive to work and drives a wedge between the take-home wage of workers and the cost of labour to firms
Result: smaller equilibrium quantity of labour due to labour supply shifting left and lower potential GDP
Tax wedge: Difference between before-tax and after-tax wage rates
Full employment quantity of labour has decreased therefore, potential GDP has decreased (therefore, aggregate supply also decreases)
Lower tax rate = lower effect on the thing
Reverse is also applicable (tax cut increases supply of labour)
o Taxes on Expenditure and the Tax Wedge
Tax wedge is only part of the wedge that affects labour-supply decisions
Taxes on consumption raises prices paid for consumption goods and services and is equivalent to a cut in the real wage
Affects labour because people don’t care about money price of wage, but what they can buy with it
o Taxes and the Incentive to Save and Invest
Tax on interest income weaken the incentive to save and drives a wedge between the after-tax interest rate earned by savers and the interest rate paid by firms
Effects are analogous to a tax on labour income, but more serious because: •
Lowers quantity of saving and investment; slowing growth rate of real GDP (versus affecting potential GDP)
•
True tax rate on interest income is higher because of the way that inflation and taxes on income interact o Effect of Tax Rate on Real Interest Rate:
Real interest rate influences investment and saving plans
Real after-tax interest rate subtracts the income tax rate paid on interest-income from real interest rate
However, taxes depend on nominal interest rate
Therefore, the higher the inflation the higher the true tax on interest income
E.x. if inflation is 6%, nominal interest is 10%, and tax is 4%, then real interest rate = 4%, which means all of that income is taxed
o Effect of Income Tax on Saving and Investment:
No effect on DLF
Weakens incentive to save and lend, therefore moving SLF to the left
Savers look at after-tax interest rate when they decide how much to save
When a tax is imposed, tax payable is measured by the difference between the original position of the SLF curve, and its position after the tax is imposed
o Tax Revenues and the Laffer Curve
A higher tax rate does not always bring in greater tax revenue
A higher tax rate brings in more revenue per dollar earned but because it decreases the number of dollars being earned, it may not raise overall tax revenue
Two forces essentially act in opposite directions on the tax revenue collected
Relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve •
Named after innovator
•
Idea originally was that tax cuts could increase tax revenue
•
Looks like an upside down hill
Tax rate – x axis; Tax revenue – y axis
T* - optimized point on Laffer curve
o Supply-Side Debate
•
Correctly argue that tax cuts could increase tax revenue and decrease deficit; however this was not applicable to the US since it was on the upward sloping part of the curve
Tax cutes as incentives work when taxes are on the wrong side of the curve
Demand-side of fiscal economics (Fiscal Stimulus) o Fiscal stimulus: use of fiscal policy to increase production and employment o Fiscal stimulus can be automatic or discretionary
Automatic fiscal policy: Triggered by the state of the economy without any action from the government – increase in unemployment benefits triggered by increased unemployment
Discretionary fiscal policy: Initiated by an act of Parliament, requires a change in spending or in a tax law; auto bail-out
o Any kind of increase in government outlays or decrease in revenues can stimulate production and jobs o Increase in expenditure on goods and services directly increase in expenditure on goods and services o Increase in transfer payments or decrease in tax revenues enables people to have more disposable income and thus increase consumption expenditure o Lower taxes also strengthen the incentive to work and invest •
Automatic Fiscal Policy and Cyclical and Structural Budget Balances: o Two items in the government budget change automatically in response to state of the economy:
Tax Revenues •
Automatic changes in tax revenues because of different changes in income (which varies with real GDP)
•
When real GDP increases in a business cycle, expansion, wages, and profits rise so tax revenues rise and the opposite also occurs
Transfer Payments •
Government creates programs that pay benefits, these benefits automatically increase when recession creates more unemployment or expansion decreases unemployment
o Automatic stimulus: Because revenues fall and outlays increase in a recession, the budget provides an automatic stimulus that helps to shrink the recessionary gap. The opposite occurs for an inflationary gap (shrunk due to a constraint in the budget) o Cyclical and structural budget balances:
To identify the government budget deficit that arises from the business cycle, we distinguish between: •
The structural surplus or deficit which is the budget balance that would occur if the economy were at full employment
•
The cyclical surplus or deficit which is the actual surplus of deficit minus the structural surplus or deficit.
•
Outlays decrease as real GDP increases, revenues increase as real GDP increases
o Discretionary Fiscal Stimulus:
Most discussion focuses on its effect on aggregate demand
Taxes influence aggregate supply and can crowd out investment and slow pace of economic growth; therefore discretionary fiscal stimulus has both supply and demand-side effects that determine effectives
Let’s discuss our discretionary fiscal stimulus by looking at its effect on aggregate demand: •
Fiscal stimulus and aggregate demand: o Changes in government expenditure and changes in taxes change aggregate demand by their influence on spending plans o Two main fiscal policy multipliers:
Government expenditure multiplier: •
Quantitative effect of a change in government expenditure on real GDP.
•
Because government expenditure is a component of aggregate expenditure, an increase in government spending increases AE and real GDP.
•
Increase in government expenditure also raises real interest rate
•
Both these effects work against each other and the strength of each determines the government expenditure
•
Usually, the crowding-out effect is strong enough to make it less than 1
Tax multiplier: •
Quantitative effect of a change in taxes on real GDP
•
•
Demand-side effects are likely to be smaller than an increase in government expenditure
•
Reason: Tax cut influences aggregate demand but by only some portion of income because rest of it gets saved
•
Similar crowding-out consequences to a spending increase
•
Tax multiplier depends on those two consequences and is usually pretty small
How a fiscal stimulus should work: o Economy has a recessionary gap o To restore full employment, government passes fiscal stimulus package o Increase in government expenditure, and a tax cut increase aggregate expenditure o A multiplier effect occurs to increase consumption expenditure, some of it negated by crowding-out effect and aggregate demand increases further o When no change in price level, economy reaches fullemployment equilibrium
•
When fiscal stimulus is removed: o Government debt grows when fiscal stimulus brings structural budget deficit o Government cuts expenditure or increases taxes to return to a balanced budget o Reduction in expenditure causes decrease in aggregate demand and opposite of fiscal stimulus occurs
•
Fiscal stimulus and aggregate supply o Taxes influence aggregate supply by driving a wedge between cost of labour and take home pay o Taxes drive real GDP growth down
o Supply side and demand side effects occur simultaneously and make the tax multiplier larger than government expenditure multiplier o Increase in government expenditure financed by borrowing increases demand for loanable funds, raises the real interest rate and lowers investment o Government expenditure multiplier is small because of private saving and deficit financed increase in government spending ends up only making a small contribution to job creation o A fiscal stimulus package that is heavy on tax cuts and light on government spending works, but it is important to get the magnitude and timing right as well
Magnitude of stimulus: Insufficient empirical evidence to pin with accuracy, almost impossible to really determine and must be estimated with error, making discretionary financial policy very risky.
Time Lags: Discretionary efforts are hampered by three time lags: •
Recognition lag o Time it takes to figure out that fiscal policy actions are needed o Involves assessing current economy and forecasting future
•
Law-making lag o Time it takes Parliament to pass laws needed to change taxes or spending o Economy might need stimulus today, but by the time law is passed, it may need something different
•
Impact lag o Time it takes from passing tax to having an actual effect on real GDP o Depends partly on speed of government agencies and partly on
timing of changes, usually spread out over a number of years o Economic forecasting remains inexact and subject to error, and make discretionary fiscal stimulus and imprecise tool for boosting production and jobs
The federal budget is an annual statement of the outlays and revenues of the government of Canada together with the laws and regulation that approve and support those outlays and revenues.
•
The federal budget pursues the government’s fiscal policy: the use of the federal budget to achieve macroeconomic objectives such as full employment, sustained long-term economic growth and price level stability.
•
Budget Making o Federal government and Parliament make fiscal policy o Discussions between Minister of finance and department of finance start the process o After all consultations, the projections made by the dept of finance, the minster develops and set of proposals which are eventually compiled as a budget to be debated in parliament
•
Highlights of 2011 Budget o Revenues
Federal government’s receipts
Come from our sources: •
Personal Income Taxes o Largest source o Paid by individuals on their income
•
Corporate Income Taxes o Smallest source of revenues o Paid by companies on their profit
•
Indirect and other taxes o Second biggest source o Include taxes like gas tax, HST
•
Investment income
o Income earned from government enterprises and investments o Outlays
Payments made by the government.
Categorized in three categories: •
Transfer payments o Largest outlay, by a huge margin o Payment to individuals, business, other governments, rest of world o Includes social welfare, subsidies, aid to developing countries
•
Expenditures on goods and services o Expenditures on final goods and services such as phones for parliament, government cars
•
Debt interest o Interest on government debt o Depends on year, sometimes exceeds other categories
o Budget balance
•
Revenues – Outlays
If revenues > outlays, budget surplus
If revenues < outlays, budget deficit
The Budget in Historical Perspective o The government has historically rarely been in surplus o Revenues are usually between 15 and 20% of GDP, while expenses are between 15 and 25% of GDP
•
Revenues: o Main sources of fluctuations are in personal income taxes o Changes in policy impact the amount of revenue coming in from income taxes
•
Outlays:
o Main source of change is in transfer payments to provincial governments o Especially high in times of crisis e.g. Alberta drought •
Deficit and Debt: o Government borrows to finance it deficit; total amount of borrowing is government debt o A persistent deficit leads to an increase in debt interest because of an increasing amount of debt incurred, the opposite also applies o Also applies to times of war where debt can increase 100% of GDP
•
Debt and Capital: o When individuals incur debts, they do so to buy capital or major assets o The government is similar in this regard o Some debt is incurred to continue investment; infrastructure, healthcare, public education yield a social rate of return far exceeding the interest rate paid by the government o Government debt > value of public capital stock, therefore some government debt was used to finance public expenditure but not all
•
Supply-side Effects of Fiscal Policy: o Economists on this side of theory believe effects of taxes to be large o (Pre-Tax) Full Employment and Potential GDP:
At full employment, real wage rate adjusts to make quantity of labour demand equal to quantity of labour supplied; without taxes
The labour equilibrium amount occurs at potential GDP, therefore real GDP equals potential GDP
o Effects of Income Tax
Tax on labour incoeme influences potential GDP and aggregate supply by changing the full employment quantit of labour
Income tax weakens incentive to work and drives a wedge between the take-home wage of workers and the cost of labour to firms
Result: smaller equilibrium quantity of labour due to labour supply shifting left and lower potential GDP
Tax wedge: Difference between before-tax and after-tax wage rates
Full employment quantity of labour has decreased therefore, potential GDP has decreased (therefore, aggregate supply also decreases)
Lower tax rate = lower effect on the thing
Reverse is also applicable (tax cut increases supply of labour)
o Taxes on Expenditure and the Tax Wedge
Tax wedge is only part of the wedge that affects labour-supply decisions
Taxes on consumption raises prices paid for consumption goods and services and is equivalent to a cut in the real wage
Affects labour because people don’t care about money price of wage, but what they can buy with it
o Taxes and the Incentive to Save and Invest
Tax on interest income weaken the incentive to save and drives a wedge between the after-tax interest rate earned by savers and the interest rate paid by firms
Effects are analogous to a tax on labour income, but more serious because: •
Lowers quantity of saving and investment; slowing growth rate of real GDP (versus affecting potential GDP)
•
True tax rate on interest income is higher because of the way that inflation and taxes on income interact o Effect of Tax Rate on Real Interest Rate:
Real interest rate influences investment and saving plans
Real after-tax interest rate subtracts the income tax rate paid on interest-income from real interest rate
However, taxes depend on nominal interest rate
Therefore, the higher the inflation the higher the true tax on interest income
E.x. if inflation is 6%, nominal interest is 10%, and tax is 4%, then real interest rate = 4%, which means all of that income is taxed
o Effect of Income Tax on Saving and Investment:
No effect on DLF
Weakens incentive to save and lend, therefore moving SLF to the left
Savers look at after-tax interest rate when they decide how much to save
When a tax is imposed, tax payable is measured by the difference between the original position of the SLF curve, and its position after the tax is imposed
o Tax Revenues and the Laffer Curve
A higher tax rate does not always bring in greater tax revenue
A higher tax rate brings in more revenue per dollar earned but because it decreases the number of dollars being earned, it may not raise overall tax revenue
Two forces essentially act in opposite directions on the tax revenue collected
Relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve •
Named after innovator
•
Idea originally was that tax cuts could increase tax revenue
•
Looks like an upside down hill
Tax rate – x axis; Tax revenue – y axis
T* - optimized point on Laffer curve
o Supply-Side Debate
•
Correctly argue that tax cuts could increase tax revenue and decrease deficit; however this was not applicable to the US since it was on the upward sloping part of the curve
Tax cutes as incentives work when taxes are on the wrong side of the curve
Demand-side of fiscal economics (Fiscal Stimulus) o Fiscal stimulus: use of fiscal policy to increase production and employment o Fiscal stimulus can be automatic or discretionary
Automatic fiscal policy: Triggered by the state of the economy without any action from the government – increase in unemployment benefits triggered by increased unemployment
Discretionary fiscal policy: Initiated by an act of Parliament, requires a change in spending or in a tax law; auto bail-out
o Any kind of increase in government outlays or decrease in revenues can stimulate production and jobs o Increase in expenditure on goods and services directly increase in expenditure on goods and services o Increase in transfer payments or decrease in tax revenues enables people to have more disposable income and thus increase consumption expenditure o Lower taxes also strengthen the incentive to work and invest •
Automatic Fiscal Policy and Cyclical and Structural Budget Balances: o Two items in the government budget change automatically in response to state of the economy:
Tax Revenues •
Automatic changes in tax revenues because of different changes in income (which varies with real GDP)
•
When real GDP increases in a business cycle, expansion, wages, and profits rise so tax revenues rise and the opposite also occurs
Transfer Payments •
Government creates programs that pay benefits, these benefits automatically increase when recession creates more unemployment or expansion decreases unemployment
o Automatic stimulus: Because revenues fall and outlays increase in a recession, the budget provides an automatic stimulus that helps to shrink the recessionary gap. The opposite occurs for an inflationary gap (shrunk due to a constraint in the budget) o Cyclical and structural budget balances:
To identify the government budget deficit that arises from the business cycle, we distinguish between: •
The structural surplus or deficit which is the budget balance that would occur if the economy were at full employment
•
The cyclical surplus or deficit which is the actual surplus of deficit minus the structural surplus or deficit.
•
Outlays decrease as real GDP increases, revenues increase as real GDP increases
o Discretionary Fiscal Stimulus:
Most discussion focuses on its effect on aggregate demand
Taxes influence aggregate supply and can crowd out investment and slow pace of economic growth; therefore discretionary fiscal stimulus has both supply and demand-side effects that determine effectives
Let’s discuss our discretionary fiscal stimulus by looking at its effect on aggregate demand: •
Fiscal stimulus and aggregate demand: o Changes in government expenditure and changes in taxes change aggregate demand by their influence on spending plans o Two main fiscal policy multipliers:
Government expenditure multiplier: •
Quantitative effect of a change in government expenditure on real GDP.
•
Because government expenditure is a component of aggregate expenditure, an increase in government spending increases AE and real GDP.
•
Increase in government expenditure also raises real interest rate
•
Both these effects work against each other and the strength of each determines the government expenditure
•
Usually, the crowding-out effect is strong enough to make it less than 1
Tax multiplier: •
Quantitative effect of a change in taxes on real GDP
•
•
Demand-side effects are likely to be smaller than an increase in government expenditure
•
Reason: Tax cut influences aggregate demand but by only some portion of income because rest of it gets saved
•
Similar crowding-out consequences to a spending increase
•
Tax multiplier depends on those two consequences and is usually pretty small
How a fiscal stimulus should work: o Economy has a recessionary gap o To restore full employment, government passes fiscal stimulus package o Increase in government expenditure, and a tax cut increase aggregate expenditure o A multiplier effect occurs to increase consumption expenditure, some of it negated by crowding-out effect and aggregate demand increases further o When no change in price level, economy reaches fullemployment equilibrium
•
When fiscal stimulus is removed: o Government debt grows when fiscal stimulus brings structural budget deficit o Government cuts expenditure or increases taxes to return to a balanced budget o Reduction in expenditure causes decrease in aggregate demand and opposite of fiscal stimulus occurs
•
Fiscal stimulus and aggregate supply o Taxes influence aggregate supply by driving a wedge between cost of labour and take home pay o Taxes drive real GDP growth down
o Supply side and demand side effects occur simultaneously and make the tax multiplier larger than government expenditure multiplier o Increase in government expenditure financed by borrowing increases demand for loanable funds, raises the real interest rate and lowers investment o Government expenditure multiplier is small because of private saving and deficit financed increase in government spending ends up only making a small contribution to job creation o A fiscal stimulus package that is heavy on tax cuts and light on government spending works, but it is important to get the magnitude and timing right as well
Magnitude of stimulus: Insufficient empirical evidence to pin with accuracy, almost impossible to really determine and must be estimated with error, making discretionary financial policy very risky.
Time Lags: Discretionary efforts are hampered by three time lags: •
Recognition lag o Time it takes to figure out that fiscal policy actions are needed o Involves assessing current economy and forecasting future
•
Law-making lag o Time it takes Parliament to pass laws needed to change taxes or spending o Economy might need stimulus today, but by the time law is passed, it may need something different
•
Impact lag o Time it takes from passing tax to having an actual effect on real GDP o Depends partly on speed of government agencies and partly on
timing of changes, usually spread out over a number of years o Economic forecasting remains inexact and subject to error, and make discretionary fiscal stimulus and imprecise tool for boosting production and jobs
