Fiscal Policy

Fiscal Policy

1. the use of the federal budget to achieve macroeconomic objectives

   • Federal Budget
     • the annual statement of the federal government’s outlays (spending) and taxes revenues
     • 2 purposes
       • The finance the activities of the federal government
       • To achieve macroeconomic objectives
     • Consists of
       • Revenues
         • Personal income taxes
         • Corporate income taxes
         • Indirect taxes (GST/HST)
         • Investment income
       • Outlays
         • Transfer payments
         • Expenditure on goods and services
         • Debt interest
           • Government Debt
             • the accumulation of government borrowing
     • Budget Balance
       • Budget balance = revenue – outlays
         • Budget surplus: revenues > outlays
         • Budget deficit: outlays > revenues
         • Balanced budget: revenues = outlays
   • Maintain full employment, economic growth, price level stability

2. Supply-Side Effects of Fiscal Policy

   • the effect of fiscal policy on employment, potential GDP, and aggregate supply
   • An income tax changes full employment quantity of labour, and therefore potential GDP
     • Introduces a “tax wedge”
       • Reduces incentives to work
       • the gap created between the before-tax and after-tax wage rates
   • Full Employment and Potential GDP
     • effects of an income tax
       • The supply of labour decreases because the tax decreases the after-tax wage rate
       • The before-tax real wage rate rises but the after-tax real wage rate falls
       • The quantity of labour employed decreases
         • Potential GDP decreases
       • The supply-side effect of a rise in the income tax decreases potential GDP and decreases aggregate supply
   • Taxes on Expenditure and the Tax Wedge
     • Taxes on consumption (GST/HST) add to the tax wedge
       • tax on consumption raises the prices paid for consumption goods and services
     • Tax wedge = income tax rate + tax rate of consumption expenditure
   • Taxes and the Incentive to Save
     • A tax on interest income lowers the quantity of saving and investment and slows the growth rate of real GDP
       • It reduces the real after-tax interest rate
     • real interest rate=nominal rate-inflation rate
     • real after-tax rate=nominal rate-inflation rate (tax rate*nominal rate)
     • the real after-tax interest rate subtracts the income paid on interest income from the real interest
       • thus lowers the return you get on your savings
     • A tax decreases the supply of loanable funds
       • A tax wedge is between real interest rate and the real after-tax interest rate
         • Investment and saving decrease
     • Tax Revenues and the Laffer Curve
       • Laffer Curve
         • the relationship between the tax rate and the amount of tax revenue collected
       • At the tax rate T*, tax revenue is maximized
       • Below T*, a rise in the tax rate increases revenue
         • People work less, but not enough to reduce total revenues
       • For a tax rate above T*, a rise in the tax rate decreases tax revenue
         • People work a lot less, decreasing total revenues

3. Fiscal Stimulus

   • Discretionary Fiscal Policy
     • a policy action that is initiated by an act on parliament
       • An increase/decrease in government spending
       • An increase/decrease in autonomous taxes or a change in the tax rate
     • affects aggregate demand
     • may also have effects on aggregate supply
     • Discretionary Fiscal Stabilization
       • An increase in government expenditure or a tax cut increases aggregate demand
         • the multiplier process increases aggregate demand further
       • A decrease in government expenditure or a tax increase decreases aggregate demand
         • The multiplier process decreases aggregate demand further
   • Automatic Fiscal Policy
     • a fiscal policy action triggered by the state of the economy with no explicit action by government
     • Automatic changes in revenues
       • Government legislates tax rates, not dollars
       • Given a tax rate, when income goes up we pay more tax in dollars
       • Given a tax rate, when income goes down we pay less dollars
     • Automatic changes in revenues
       • Many government spending programs depend on state of the economy
       • Government spending more on employment insurance in bad times
       • when the economy is in recession, transfer payments rise
     • During a recession
       • Revenues will fall due to lower incomes
         • Outlays will rise from increase in transfer payments
           • This creates a stimulus that helps limit recessionary gaps
     • During a boom
       • Revenues rise due to higher incomes
         • Outlays fall from reduction in transfer payments
           • Provides restraint that limits inflationary gaps
   • Cyclical and Structural Balances
     • Structural Surplus or Deficit
       • the budget balance that would occur if the economy were at full employment and real GDP were equal
     • Cyclical Surplus or Deficit
       • is the actual surplus or deficit minus the structural surplus or deficit
   • Fiscal Stimulus and Aggregate Demand
     • Changes in government spending or taxes shift the aggregate demand curve
     • Government Expenditure Multiplier
       • the magnification effect of a change in government expenditure on goods and services on real GDP
     • if the government finances spending by borrowing, there is crowding out
     • Tax Multiplier
       • quantitative effect of a change in taxes on real GDP
         • A decrease in taxes increases disposable income
           • This in turn increases consumption and increases aggregate demand
   • Fiscal Stimulus and Aggregate Supply
     • Increases in income tax may reduce pay, and therefore unemployment
     • Increases in capital income tax may reduce incentive to save, and therefore reduce GDP growth
   • Limitations of Discretionary Fiscal Policy
     • Recognition lag
       • the time it takes to figure out that fiscal policy action is needed
     • Law-Making Lag
       • the time it takes parliament to pass the laws needed to change taxes or spending
     • Impact Lag
       • the time it takes form passing a tax or spending change to its effect on real GDP being felt

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