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Eco U4O1 #4
KK: the effect of automatic and discretionary changes in the budget on the budget outcome
and government (public) debt
KK: the effect of automatic stabilisers on AD and the business cycle.
Automatic stabilisers: are the changes to the budget that occur automatically with changes in the level of economic activity. Also referred to as the ‘cyclical’
component of the budget. Automatic stabilisers are policies that are built into the budget e.g. income tax, transfer payments
Discretionary stabilisers: are deliberate policy decisions designed to change receipts or expenditure in an effort to influence economic activity. Also referred to
as the ‘structural’ component of the budget.
**NOTE: IT IS SO ESSENTIAL YOU UNDERSTAND THESE TWO CONCEPTS FOR THE EXAM
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4. Effect of automatic and discretionary stabilisers on the business cycle and the
budget outcome
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Understanding Automatic StabilisersSo, remember what the budget is: it is an estimate of the incoming receipts and outgoing
expenditure for the Commonwealth Government for the year ahead. The key word here is
estimate. Do they know exactly how much income they are going to receive? No. Do they know
exactly how much they are going to spend? No. Because some of this is dictated by a rise or fall
in economy activity (hence why they are also called the cyclical component of the budget i.e. the
business cycle).
For example, the estimated underlying budget outcome for 2018-19 is -14.5B, but what happens
if economic activity slows down to below what the government are expecting? If this happens
then not only will the Government receive less income and company tax receipts, but more
people are likely to qualify for transfer payments (welfare), automatically increasing government
expenditure and therefore the budget outcome will automatically turn into a much larger deficit
than anticipated.
The impact of Automatic Stabilisers on recent budget outcome
Example: the estimated budget outcome for 2017-18 was a deficit of $29.1B, but in the Mid-Year
Economic and Fiscal Outlook (MYEFO) that the government released in December 2016, the
deficit was estimated to actually be 18.2B because they received more income tax than they
originally thought they would.
Why is an automatic stabiliser called a ‘stabiliser’?
Because thinking about the business cycle, if we are in a boom period with very high economic
activity more people are likely to move to a higher tax bracket and pay more tax, reducing their
disposable income. On the other side of this, during a recession more people will qualify for
transfer payments like Newstart and this will stimulate AD to some extent (SEE NEXT PAGE)
Automatic Stabilisers and the impact on government (public) debt
Automatic stabilisers is the result of changes in economic activity during a fiscal year that can
alter the budget outcome. For example, increases in economic activity (associated with
increased consumer and business confidence and overseas economic growth) should result in
an increase in direct taxation in the form of increased sales tax (GST) and possibility of
increased levels of income tax (associated with increased levels of employment). As such, this
should result in a decrease in welfare dependency and a decrease in expenditure.
Eco U4O1 #4
Main types of automatic stabilisers
Progressive income taxes
In the upswing of the business cycle, as real GDP and incomes rise, government tax
revenues automatically increase, causing after-tax (disposable) income to be lower than it
would otherwise be. The downward pressure on disposable incomes acts to dampen
aggregate demand, and this tends to counteract the economic expansion, or make it smaller
than it would otherwise be.
In a recession, the opposite occurs. With real GDP and incomes falling, government tax
revenues automatically decline, causing after-tax (disposable) income to be higher than it
would otherwise be, exerting an upward pressure on aggregate demand, which reduces the
severity of the recession.
The more progressive an income tax system, the greater the stabilising effect on economic
activity.
Unemployment benefits
In a recession, as real GDP falls and unemployment increases, unemployment benefits rise
as they are offered to more unemployed workers. If there were no unemployment benefits,
unemployed workers’ spending would fall quite dramatically, putting a strong downward
pressure on consumption spending and aggregate demand.
However, the presence of unemployment benefits means that as workers become
unemployed, their consumption will be maintained to some extent as their benefits partially
replace their lost income, thus lessening the downward pressure on aggregate demand. In
an expansion, unemployment benefits are reduced as unemployment falls; therefore,
consumption increases less than it would in the absence of unemployment benefits.
It is important to bear in mind that a progressive tax system and unemployment benefits cannot by themselves stabilise the economy and eliminate inflationary and recessionary gaps on their own. They can only help reduce the severity of economic fluctuations.
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Bracket Creep
Bracket creep or ‘fiscal drag’ is when, in a progressive tax system like Australia, higher
incomes as a result of high economic activity lead to households moving up to a higher tax
bracket (so they are being taxed more).
This has two main effects:
it increases the tax revenue collected by the government
it possibly decreases household real disposable income and reduces purchasing
power
Q: Explain the impact that bracket creep would have on the budget outcome
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Q: Explain the impact that bracket creep would have on the business cycle and AD
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Eco U4O1 #4
Q: Explain how bracket creep can lead to a disincentive to work harder (which may decrease
productivity).
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Q: Explain the role of automatic stabilisers in stabilising economic activity. In your answer,
refer to the business cycle.
6 marks
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Understanding Discretionary Stabilisers
Discretionary stabilisers are deliberate policy decisions on how to change receipts and
outlays. For example, a decision to cut spending from a particular department is a
discretionary decision. Similarly, a decision to increase spending on roads is another
discretionary policy. These policies are used to try and influence the level of economic
activity either now or in the future.
Impact of discretionary stabilisers on government debt and the budget outcome
The impact of discretionary stabilisers on the budget outcome is a lot more straight forward.
Unlike automatic stabilisers, the receipts/outlays from discretionary policies can be planned
and estimated with much greater accuracy. However, discretionary policies often still need to
be approved by the Senate and if they do not get approved then this will impact the budget
outcome. For example, in 2014-15 the Government want to introduce a policy where
previously bulk-billed (free) medical appointments would have to pay a $7 fee for a Doctor’s
visit. This was an extremely unpopular policy and was not approved by the Senate, therefore
all the estimated receipts the Government were hoping to get from that policy was now gone.
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Q: The estimated underlying budget outcome for 2018-19 is a deficit of $14.5B (or -14.5B).
In reference to automatic stabilisers, explain one type of government revenue and one type
of government expenditure that would lead to the deficit being larger than expected.
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Q: Explain one discretionary and one automatic stabiliser that could cause the budget deficit
to decrease and the impact that this is likely to have on the level of net public debt.
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Q: Explain why the level of public debt will decrease during a boom in economic activity
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Q: Explain the impact that a recession will have on the budget outcome. In your answer,
refer to automatic stabilisers.
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Question 1Which of the following is most correct? A budget deficit (such as occurred between 2008–09 and
2016–17) is where:
a. the total value of government receipts is more than the total value of government expenses.
b. the total value of government expenses is less than the total value of receipts.
c. the total value of government asset sales and taxes is more than the total value of government
consumption (G1) and government investment (G2) spending.
d. the total value of government receipts is less than the total value of government expenses.
Question 2 The main difference between the headline budget balance and underlying budget balance is that:
a. the underlying balance excludes one-off volatile items like asset sales and interest repayments by
state governments.
b. the headline balance excludes transfers like welfare outlays, which vary from year to year.
c. the underlying balance removes the effect of automatic stabilisers.
d. the underlying balance removes the impact of inflation on the values of receipts and outlays.
Question 3 Concerning budgetary policy, which statement is generally false?
a. A deficit budget may be financed by foreign and/or local borrowing.
b. A larger deficit budget as a ratio to GDP may stimulate domestic economic activity and, if the
economy is already at its capacity, this may cause demand inflation.
c. A deficit budget in a recession financed by local borrowing from the financial sector may
unintentionally tend to drive up domestic interest rates, causing a possible degree of conflict with RBA
efforts to run an expansionary monetary policy with lower interest rates.
d. In itself, the shift towards a bigger surplus budget or a smaller deficit is generally regarded as
expansionary, and should help to lower unemployment and accelerate economic growth.
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Question 4 Between 2014–15 and 2019–20, the federal government initially planned to convert a headline de cit
of $48.5 billion into a small surplus. Theoretically, this could be achieved using:
a. increased asset sales, automatic increases in tax collections and bracket creep, and the
introduction of discretionary new taxes.
b. a discretionary reduction in government consumption (G1) and government investment (G2)
spending.
c. automatic and discretionary cuts in welfare outlays and other transfer payments.
d. all of the above.
Question 5What factor(s) might theoretically help to explain why the small budget surplus that the treasurer
predicted would be achieved by 2019–20 ended up as a budget deficit; or why the actual deficit ended
up being nearly twice as big as that projected; or why the predicted surplus finished as a budget
deficit?
a. More rapid inflation and faster economic growth than initially expected
b. Lower unemployment than initially expected
c. An unexpected boom among our trading partners overseas
d. Lower terms of trade, along with slower levels of domestic economic activity and higher rates of
unemployment than initially expected.
Question 6 Which statement is correct? An increase in G2 spending on public health, education, housing and
transport will normally tend to:
a. decrease cyclical unemployment.
b. decrease job vacancies.
c. decrease demand inflation in the short term.
d. decrease the rate of economic growth by slowing AD.
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Eco U4O1 #4
Key Knowledge covered:
the stance of budgetary policy: expansionary or contractionary
The stance of budgetary policy: expansionary or contractionary
An expansionary budgetary or fiscal policy stance. Budgets that seek to stimulate AD
and economic activity (because there is a slowdown in the economy) are said to be
expansionary budgets. They typically include reductions in receipts and/or rises in outlays.
Hence, expansionary budgets generally involve either one of the following:
an increase in the size of the budget deficit against the previous year (such as a rise in the
deficit from $30 billion to $50 billion)
a cut in the size of the budget surplus against the previous year (such as a decrease in the
surplus from $20 billion to $5 billion).
A contractionary budgetary or fiscal policy stance. Budgets that seek to slow the growth
of AD and economic activity (because there is an inflationary threat) are said to be
contractionary budgets. They typically include rises in revenue relative to expenses.
Therefore, contractionary budgets generally involve either one of the following:
a reduction in the size of the budget deficit against the previous year (such as a cut in
the deficit from $30 billion to $10 billion)
a rise in the size of the budget surplus against the previous year (such as a rise in
the surplus from $10 billion to $20 billion).
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The stance of budgetary policy: expansionary or contractionary
Eco U4O1 #4
The stance of the 2018-19 Budget
For example, this year the deficit is $14.5B which seems expansionary, but if you compare
this year’s outcome to the 2017-18 budget which was a deficit of $18.2B, we see that this
year’s deficit is less, and therefore will have a mildly contractionary effect on the economy
(as there is approximately $4B less being injected into the economy than last year).
So, in the exam this year if you were required to discuss the budget stance for this year’s
budget you would say it is a mildly contractionary stance (or less expansionary is fine too).
Q: Referring to the data provided in the table above, outline the stance of the 2017-18 Budget
and the stance of the 2018-19 budget.
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Q: Explain the impact that the stance of the 2018-19 budget would have on Aggregate Demand
and the economy, ceteris paribus.
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