Fiscal PolicyChapter 13

SECOND CANADIAN EDITION

MACROECONOMICSPaul Krugman | Robin Wells

Iris Au | Jack Parkinson

© 2014 Worth Publishers

• What fiscal policy is and why it is an important tool in managing economic fluctuations

• Which policies constitute an expansionary fiscal policy and which constitute a contractionary fiscal policy

• Why fiscal policy has a multiplier effect and how this effect is influenced by automatic stabilizers

• Why a large public debt may be a cause for concern

WHAT YOUWILL LEARN

IN THIS CHAPTER

The Economic Importance of GovernmentGovernment Spending and Tax Revenue for Some High-Income Countries in 2007

What Does Government Do?

Government Spending (including transfers) in Canada, 2007

How Does Government Pay for its Spending?

Sources of Tax Revenue in Canada, 2007

The Government Budget and Aggregate Spending• Fiscal policy is the use of taxes (T), government transfers

(TR), or government purchases of goods and services (G) to shift the aggregate demand curve (AD).

• Recall that: GDP = C + I + G + X-IM

Fiscal policy works mainly through either: G (government spending) or; through the effects of tax and transfer policies on C

(consumption spending).

More minor possibilities? Taxes could affect investment (I); trade taxes (tariffs) could affect imports (IM).

Expansionary Fiscal Policy: Increasing AD• Expansionary fiscal policy raises AD. How?

Increases government spending on goods and services (G)

e.g. infrastructure spending

Cuts taxes e.g. lower income tax rates, leaves households with more disposable income so consumption spending (C) rises.

Raises transfers e.g. increase EI payments to the unemployed, this raises disposable income and raises C.

The result: AD shifts right! These measures can eliminate a recessionary gap (see diagram).

Expansionary Fiscal Policy

Contractionary Fiscal Policy: Lowering AD• Contractionary fiscal policy lowers AD. How?

Lower government spending on goods and services (G) Raise taxes e.g. raise income tax rates, households have less

disposable income so consumption spending (C) falls.

Cut transfers e.g. decrease EI payments to the unemployed, this lowers disposable income and raises C.

The result: AD shifts left! These policies can be used to eliminate an inflationary gap. (see diagram)

Contractionary Fiscal Policy

Can Expansionary Fiscal Policy Work? Some Objections

• Government spending displaces private spending $1 for $1. There is only so much income so that spent by government reduces

spending by others. This is wrong since the extra spending can change output or income

especially in recessions.

• Government borrowing to finance fiscal policy raises interest rates which crowds out investment spending so rise in G is offset by a fall in I. This makes some sense (see loanable funds model) But this effect is likely to be weaker in a recession if extra G raises real GDP.

• “Ricardian equivalence”. Increased spending now means higher future taxes – households will respond by spending less, saving more in anticipation of higher future taxes. This assumes households are very forward-looking. Even if correct the reduced consumer spending will be spread across many

years while the rise in G happens now. So AD will rise.

A Cautionary Note: Lags in Fiscal Policy

• With fiscal policy, there is an important reason for caution: there are significant lags in its use.

The government realizes there is a recessionary/inflationary gap by collecting and analyzing economic data takes time

Government develops a spending plan takes time

Implementation of the plan (spending the money takes time (e.g. planning, approvals, awarding contracts etc.)

Will the problem (gap) still exist when the policy takes effect?

i.e. will the SRAS already have shifted to eliminate the gap?

Another Problem: Level of Potential Output • The direction of fiscal policy depends on whether GDP is

above or below its “potential” or “full-employment” level.

• Potential output is not directly observed. It must be estimated or inferred from the behavior of other

macroeconomic variables. Incorrect estimates can result in policy mistakes. Fiscal policy makes most sense when departures from

potential are large and so the direction of policy is clear.

• US in 2015 provides an example of the problem. Unemployment rate suggests they are at or near potential. Employment as a share of population and wage-price behavior

suggest it is still below potential.

ECONOMICS IN ACTION

What Was in Canada’s 2009 Economic Action Plan

• The 2009-2010 budget impact of the Action Plan can be broken down into four categories: Infrastructure and other spending $10.97 billion (48%) Tax cuts $7.56 billion (33%) Transfer payments to persons $2.19 billion (10%) Transfer payments to lower level governments $2.03

billion (9%)

• The Action Plan included elements that affected G (infrastructure spending), taxes and transfers: all were intended to boost AD.

Fiscal Policy and the Multiplier

• Fiscal policy has a multiplier effect on the economy.

• Expansionary fiscal policy leads to an increase in Aggregate Demand larger than the initial rise in aggregate spending caused by the policy.

• Conversely, contractionary fiscal policy leads to a fall in Aggregate Demand larger than the initial reduction in aggregate spending caused by the policy.

• As in Chapter 11 multiplier works through interdependence between income and spending. Critical parameter: MPC = marginal propensity to consume.

Fiscal Policy and the Multiplier• The size of the shift of the aggregate demand curve depends on

the type of fiscal policy. Increases in G have a larger effect than equivalent-sized

changes in taxes or transfers. Why? A rise in G directly increases spending by the amount of the increase; while only a share of the tax cut/transfer increase is spent.

• The government spending multiplier works just like Ch. 11: Say we have a $50 billion rise in G:Round 1: $50 b. rise in G immediately raises incomes by $50 b.Round 2: MPC of this is spent on consumer goods, leading to

MPC x $50 billion more output and incomeRound 3: MPC of round 2 income is spent giving MPC2 x$50 billion

extra spending etc.End result? $50 billion x 1/(1 − MPC) of extra spending from

$50 billion of extra G.

Tax and Transfer Multiplier• Say we have a $50 billion tax cut or $50 billion transfer increase.

Round 1: Spending increases by MPC x $50 billion since only MPC of the extra income is spent, income rises by

MPC x $50 billion.

Round 2: MPC of the extra income from round 1 is spent so incomes rise in round 2 by MPC2 x$50 billion

i.e. at each round the effect is scaled down (compared to the effect of a rise in G) by multiplying by

MPC

End result? $50 billlion x MPC/(1-MPC) of extra spending from the $50 billion tax cut or transfer increase.

Multiplier Effects of Changes in Taxes and Government Transfers

Hypothetical Effects of a Fiscal Policy with Marginal Propensity to Consume (MPC) of 0.5 (∆Y=change in Y, ∆G=change in G)

So the multiplier is larger for the rise in G than for a transfer increase or tax cut.

Discretionary and Automatic Fiscal Policy

• Discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

i.e. changes to G or to tax or transfer policies (like above)

• Automatic stabilizers don’t require a discretionary change in policy. They work via the effect of existing policies on the size of the multiplier and automatically reduce the effect of fluctuations in spending. How? Spending rise, incomes rise but part of the rise goes to

government as taxes or reduced transfers leaving less for additional spending (multiplier smaller).

Spending falls, incomes fall but part of the fall is reduced taxes, and part is offset by rising transfers) so spending falls by less than if there was no tax-transfer system.

ECONOMICS IN ACTION

Multipliers and the 2009 Economic Action Plan • Canada’s Economic Action Plan was an example of

discretionary fiscal expansion. • Based on the Department of Finance’s Canadian Economic

and Fiscal Model, the stimulus plan would create an estimated 220,000 jobs by the end of 2010.

• The size of the multipliers on items in the stimulus plan ranges from 0.3 (corporate income tax change) to 1.7 (measures for low-income people).

(Source: Parliamentary Budget Officer Kevin Page (from T-Bay!))

ECONOMICS IN ACTION

Multipliers and the 2009 Economic Action Plan

The Budget Balance• How do government surpluses and deficits fit into the analysis of

fiscal policy?

• Are deficits ever a good thing and surpluses a bad thing?

• Recall from Chapter 10: SPublic = T – TR – G(T= taxes, TR = Transfers, G = government spending on goods and services)

• Other things equal, discretionary expansionary fiscal policies—increased G, higher TR, or lower T—reduce the budget balance for that year.

That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger.

• Automatic stabilizers also affect this balance in the same direction. Recessions: T falls, TR rises (deficit growing or surplus shrinks)

The Budget Balance

• Conversely, contractionary fiscal policies—smaller G, smaller TR, or higher T—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

• Automatic stabilizers work in the same direction during a boom. Booms: T rising, TR falling (deficit shrinks or surplus grows)

The Budget Balance

• Some of the fluctuations in the budget balance are due to the effects of the business cycle.

• To separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output.

See graph (next slide): notice actual deficit is greater than cyclically-adjusted budget when an economy is recovering from a recession

The Budget Balance (Note: Budget deficit >0 means T-TR-G <0 ; blue bars: recessions )

Should the Budget Be Balanced?

• Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.e.g. recession ↓T, ↑TR helps maintain disposable income and

the level of consumer spending. Requiring a balanced budget would raise T and cut TR and G in recessions making AD fall further. (US states in the Great Recession)

• Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary. Will politicians be biased towards deficits if no rules?

(European Union has tried with mixed success to establish rules)

Pitfalls

Deficits versus Debt • Persistent budget deficits have long-run consequences because they

lead to an increase in public debt.

• A deficit is the difference between the amount of money a government spends and the amount it receives in taxes over a given period. The Canadian budget deficit in the fiscal year of 2011-2012 was $26.2 billion.

• A debt is the sum of money a government owes at a particular point in time. The Canadian federal debt was at $582.2 billion at the end of the 2011-2012 fiscal year.

i.e. debt reflects past deficits and surpluses.

• Deficits and debt are linked, because government debt grows when governments run deficits.

Problems Posed by Rising Government Debt

• Public debt may crowd out investment spending, which reduces long-run economic growth.

(see Ch. 10 and loanable funds model)

• And in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil.

In 2009, the government of Greece ran into a financial wall when most investors lost confidence in Greece’s financial future and no longer willing to lend to the Greek government.

By the end of 2011, Greece had to pay an interest rate around 10 times the rate Germany. After falling 2012-14 rates on Greek debt have risen in recent months (recent election)

Long-Run Implications of Fiscal Policy

Long-Run Implications of Fiscal Policy: Money Finance?

• Can’t a government that has trouble borrowing just print money to pay its bills?

• Yes, it can, but this leads to another problem: inflation.

• Episodes of very high inflation are associated with this type of money finance.

e.g. Zimbabwe 2008, Germany early 1920s, Latin America at various times.

Deficits and Debt in Practice

• A widely used measure of fiscal health is the debt-to-GDP ratio.

• This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.

• Just before the 2008-2009 recession, the combined amount of government debt in Canada was about $23,000 per capita in which two thirds of this debt came from the federal government and one third was debt issued by lower levels governments.

• How do we compare?

Global Comparison: The Canadian Way of Debt

Canada’s Federal Deficits and Debt

FOR INQUIRING MINDS

What Happened to the Debt from World War II?

• The government paid for World War II by borrowing on a huge scale. By the war’s end, the public debt was more than 100% of GDP,

and many people worried about how it could ever be paid off.

• The truth is that it never was paid off. In 1946, net public debt was $13.4 billion. After a few years of post-war budget surpluses, the public debt was back up to $13.4 billion by 1962. By then nobody was worried about the fiscal health of the

Canadian government because the debt-to-GDP ratio had fallen below 40%.

FOR INQUIRING MINDS

What Happened to the Debt from World War II?

• Vigorous economic growth, plus mild inflation, had led to a rapid rise in nominal GDP. The experience was a clear lesson in the peculiar fact that

modern governments can run deficits forever, as long as they aren’t too large.

ECONOMICS IN ACTION

Austerity Dilemmas

• Suppose that lenders begin doubting whether a government can or will repay its debts, and lending dries up. What can that government do?

• The usual answer is fiscal austerity. The government in question cuts spending and raises taxes,

both to reduce its need for borrowed funds and to demonstrate to potential lenders that it has the ability and determination to do what’s necessary to honor its debts.

1. The government plays a large role in the economy, collecting a large share of GDP in taxes and spending a large share both to purchase goods and services and to make transfer payments, largely for social insurance.

Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. But many economists caution that a very active fiscal policy may in fact make the economy less stable due to time lags in policy formulation and implementation.

Summary

2. Government purchases of goods and services directly affect aggregate demand, and changes in taxes and government transfers affect aggregate demand indirectly by changing households’ disposable income.

Expansionary fiscal policy shifts the aggregate demand curve rightward; contractionary fiscal policy shifts the aggregate demand curve leftward.

Summary

3. Only when the economy is at full employment is there potential for crowding out of private spending and private investment spending by expansionary fiscal policy. The argument that expansionary fiscal policy won’t work because of Ricardian equivalence – that consumers will cut back spending today to offset expected future tax increases – appears to be untrue in practice. What is clearly true is that very active fiscal policy may make the economy less stable due to time lags in policy formulation and implementation.

Summary

4. Fiscal policy has a multiplier effect on the economy, the size of which depends upon the fiscal policy. Except in the case of lump-sum taxes, taxes reduce the size of the multiplier.

Expansionary fiscal policy leads to an increase in real GDP, while contractionary fiscal policy leads to a reduction in real GDP.

Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-size changes in taxes or transfers.

Summary

5. Rules governing taxes—with the exception of lump-sum taxes—and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle.

In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

Summary

6. Some of the fluctuations in the budget balance are due to the effects of the business cycle.

To separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output.

Summary

7. Canadian government budget accounting is calculated on the basis of fiscal years.

Persistent budget deficits have long-run consequences because they lead to an increase in public debt.

This can be a problem for two reasons. Public debt may crowd out investment spending, which reduces long-run economic growth. And, in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil.

Summary

8. A widely used measure of fiscal health is the debt–GDP ratio. This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.

However, a stable debt–GDP ratio may give a misleading impression that all is well because modern governments often have large implicit liabilities.

The largest implicit liabilities of the Canadian government come from benefits such as Old Age Security (OAS), Guaranteed Income Supplement (GIS), Canada Health Transfer (CHT), and Canada Social Transfer (CST).

Summary

• Social insurance• Expansionary fiscal policy• Contractionary fiscal policy• Lump-sum taxes• Automatic stabilizers• Discretionary fiscal policy• Cyclically adjusted budget

balance• Fiscal year• Public debt• Debt-to-GDP ratio• Implicit liabilities

Key Terms