a. The objectives of the fiscal policy are to influence aggregate demand using such tools as taxes and government spending.
i. Taxation as a tool is mainly used for wealth redistribution.
ii. Government spending on the other hand influences aggregate
b. The effectiveness of fiscal policies depends on the particular economy, and there is debate over whether particular tools are helpful:
i. Keynesians believe that fiscal policy is effective in affecting aggregate demand.
ii. Monetarists believe that fiscal policy effectiveness is only temporary.
c. Government receipts are generally taxes on income and taxes on goods and services.
d. Fiscal policy examples:
i. Expansionary fiscal policy:
# Increase infrastructure spending
# Cut personal income taxes
# Cut sales taxes
# Cut corporate taxes
ii. Contractionary fiscal policy:
# Increase taxes
# Reduce Spending
e. A budget surplus exists if government revenues exceed government spending.
A budget deficit, on the other hand, exists if government revenues are less than government spending.
f. Automatic stabilizers are self-correcting mechanisms. Some of the examples of automatic stabilizers are:
i. In a downturn, government transfer payments increase (for example, unemployment benefits).
ii. In a booming economy, taxes increase (especially if progressive).
These stabilizers may exaggerate or exacerbate fiscal policies if not taken into account by the government.
g. The national debt of a country increases with government deficits.
1.1. Fiscal Policy Tools
On the expense side, the most commonly used fiscal policy tools are:
a. Transfer Payments: These are automatic payments, such as welfare and social security.
b. Government Spending: These are the discretionary payments by the government for goods and services, such as health, education, defense, etc.
c. Capital Expenditure: These are the spending on infrastructure that enhances the capital stock productivity. These are also innovation investments.
Government spending may be justified on economic and social grounds
On the revenue side, some of the important fiscal policy tools are:
a. Direct Taxes: These include the taxes directly imposed on the incomes of the people, which are borne by the payer of the tax.
b. Indirect Taxes: These are the taxes that are not borne by the payer of the taxes, such as excise duties, sales tax, taxes on gambling incomes, etc.
Taxes generate government revenues and may be used for income redistribution. Some of the desirable properties of a tax policy are:
a. Simple: The taxes should be both simple to calculate and pay.
b. Efficient: The taxes should not affect the major decisions of the payers.
c. Fair: The fairness of taxes should include two aspects:
i. Horizontal equity, e. those individuals in the same situations should pay the same levels of taxes.
ii. Vertical Equity, e. richer people should pay more taxes, or the taxes should have progressive rates.
d. Sufficient Revenues: The taxes should generate revenues sufficient to pay for the government’s expenditure and other needs.
1.1.1. Advantages of Fiscal Policy Tools
The biggest advantage of the fiscal policy tools such as indirect tax is that it can be adjusted immediately, also:
a. it influences the spending instantly,
b. it generates revenues efficiently, and
c. discourage undesirable behavior, in the sense that social policies can be affected quickly using excise taxes (e.g., on tobacco).
1.1.2. Disadvantage of Fiscal Policy Tools
The biggest disadvantages of the fiscal policy tools are:
a. Direct taxes take time to change, and
b. Capital spending takes planning and time to implement, which makes it a slow-acting and possibly ill-timed tool.
1.2. Fiscal Multiplier
a. If we recall, our disposable income is the national income minus the net taxes. That is:
| YD = Y – NT = (1 – t) × Y |
b. The marginal propensity to consume (MPC) is the proportion of additional income that is spent on consumption. And the complement of MPC is the marginal propensity to save (MPS).
|
MPS = 1 – c |
where c is the marginal propensity to consume.
MPC determines the effectiveness of fiscal policies that affect income.
c. The fiscal multiplier is a measure of the effectiveness of fiscal policy and is the change in output for a change in output for a change in spending or taxation. Thus,
| Fiscal Multiplier = 1 / (1-c) |
where marginal propensity to consume lies between 0 and 1.
d. Given all of the above, household spending is an MPC time the disposable income. That is,
| Household Spending = c (1 – t) Y |
e. So, if the government spending increase, the disposable income will increase at the rate of (1-t)×G. And, our consumption will increase MPC times the increase in disposable income, i.e. c (1-t) G.
The next person who receives this as his income will witness an increase in his disposable income at the rate (1-t) c (1-t) G, and so on.
f. Thus, with taxes, the fiscal multiplier can be calculated as:
| Fiscal Multiplier With Taxes = 1 / [1 – c (1 – t)] |
1.3. Effectiveness of Fiscal Policy
a. The budget (whether surplus or deficit) may not indicate a government’s fiscal stance because automatic stabilizers may affect the budget. We should, therefore, look at the structurally adjusted (or cyclically adjusted) budget deficit.
b. To structurally adjust the same, we add the budget balance at full employment to the current deficit.
c. Fiscal policy is difficult to use to stabilize aggregate demand because there are lags.
i. There is a lag between a slowing economy and the data to assess such slow-down. This is called the recognition lag. This is mainly due to imperfect information.
ii. It may take several months to implement the required policies, due to the action lag. This is mainly due to imperfect decision-making.
iii. It may take time for there to be any impact on the economy due to the impact lag. This is due to imperfect execution.
d. It is difficult to predict where the economy is heading apart from any fiscal policy, and some policies may make things worse.
e. Some of the examples of issues with the fiscal policies are:
i. Whether the increase in government spending will lead to inflation?
ii. If the deficit or GDP is large enough already, extra deficits may not be possible.
iii. Full employment is not always static.
iv. Government borrowing may crowd out more productive private borrowings.