Transcript Fiscal policy

Fiscal policy
1. State Budget
2. Supply Side Economy
3. Government Expenditure
Multiplier
4. Tax Multiplier
5. Expansionary Fiscal Policy
6. Crowding Out Effect
Fiscal policy

Fiscal Policy is the process of shaping
taxation and public expenditures in order
to help to reduce business cycle
fluctuations and to maintain high economic
growth.
State Budget
Governments use budget to control and
record their fiscal affairs.
 A budget shows, for a given year, the
planned expenditures of government
programs and the expected revenues from
tax systems.

State Budget

State budget revenues:
◦
Tax Revenues:
 Tax on income, profit and capital gain
 Property tax
 Domestic taxes on goods and services
(value added tax, excise taxes, road tax)
◦ Non-tax revenues
 Administrative and other charges and payments
 Capital income
 Interest on domestic and foreign credits, loans
and deposits
◦ Grants and transfers
◦ Revenues from financial transactions
(repayments of credits and loans)
State budget expenditure
◦
Current expenditures
Wages, salaries,
 Insurance premiums and contributions to
insurance companies and to the National Labour
Office,
 Current transfers (state social benefits)
 Payments of interest and other payments in link
with loans received
 Purchases of goods and services

Capital expenses
◦ Expenses in link with financial transactions
(credits and loans extended)
◦
Budget Surplus and Deficit
A budget surplus occurs when all taxes
and other revenues exceed government
expenditures.
 A budget deficit occurs when
expenditures exceed revenues.
 When expenditures and revenues are
equal during a given period, the
government has a balanced budget.

Structural and Cyclical Budget
The structural budget calculates what
government revenues, expenditures and
deficits would be if the economy were
operating at potential output.
 The cyclical budget calculates the effect
of the business cycle on the budget –
measuring the changes in revenues,
expenditures, and deficits that arise
because the economy is not operating at
potential output.

Financing Deficit
Government can borrow funds from the other
sectors of the economy. This involves the selling of
government securities such as treasury bonds.
Government competes with the private sector for
domestic savings, creating what is referred to as a
“crowding out effect”.
 Government supports export.
 Government sells securities to the central bank.
This form of borrowing from the CB basically means
that the government prints money to finance the
deficit.
 Government borrows funds from international
financial markets. If government borrows funds from
overseas it can reduce the crowding out effect.

Fiscal Policy Instruments
Automatic stabilizers act to reduce
business-cycle fluctuations.
 Discretionary fiscal policy is one in
which government changes tax rates or
spending programs. In contrast to
automatic stabilizers, discretionary policies
generally involve passing legislation to
change the structure of the fiscal system.

Automatic Stabilizers

Progressive taxes – the average tax
rate rises as income rises. In inflationary
times, an increase in tax revenues will
lover personal income, dampen
consumption spending, reduce aggregate
demand, and slow the upward spiral of
prices and wages.
Automatic Stabilizers
Unemployment insurance, welfare
and other transfers are designed to
supplement incomes and relieve economic
hardship.
 Subsidies on production in the farm
sector.

Discretionary Fiscal Policy
Public works include public investment
projects designed to create jobs for the
unemployed. Those projects are highly capitalintensive and long-duration ones.
 Public employment projects are designed to
hire unemployed people for periods of a year or
so, after which people can move to regular jobs
in the private sector.

Discretionary Fiscal Policy

Varying tax rates can be used to either
stimulate or restrain an economy. Once
taxes have been changed, consumers react
quickly; a tax cut is spread widely over the
population, stimulating spending on
consumption goods.
Supply Side Economy
Toward the end of the 1970s, critics of the
conventional approach to
macroeconomics argued that economic
policy had been too oriented toward the
management of aggregate demand.
 New school of supply side economics
proposed large tax cuts to reverse slow
economic growth and slumping
productivity growth.

Supply Side Economy

Three central features of supply side
economics:
Retreat from Keynesian demand-management
policies;
◦ Emphasis on incentives and supply effects;
◦ Advocacy of large tax cuts
◦
Laffer Curve
Tax Revenues
D
B
A
0
t1 t2
C
t3
Forbidden zone
100% Tax Rate
Government Expenditure
Multiplier
The government expenditure multiplier (g)
is the increase in GDP resulting from an increase
in government expenditures on goods and
services.
 The government expenditure multiplier (g) is the
same number as the investment multiplier:

1
g
1  MPC
ΔGDP = g . ΔG
Government Expenditure
Multiplier
C,I,G
C + I + G + ΔG
E2
C+I+G
E1
0
Q1
Q2 QP
Q
Tax Multiplier

Tax multiplier (t) is smaller than the
expenditure multiplier by a factor equal to
the MPC: t = g . MPC
 MPC  MPC
t

1  MPC
MPS
ΔGDP = t . ΔT
Tax Multiplier
C,I,G
C2 + I + G
E2
C1 + I + G
E1
0
Q1 Q2
QP
Q
Expansionary Fiscal Policy
AS
When the economy is
operating under
the potential output, in
the short-run, rightward
shift of AD curve has
effect on real output
with only a small effect
on prices.
P
P1
E1
E
P
AD1
AD
Q
Q1QP
Q
Expansionary Fiscal Policy
LRAS = QP
P
E1
P1
Lung-run expansionary
fiscal policy , will
primarily raise
prices and nominal GNP
with no effect on
real GNP.
E
P
AD1
AD
0
QP
Q
Restrictive Fiscal Policy

Restrictive fiscal policy includes:
◦ Reduction in government spending
◦ Reduction in trasfer payments
◦ Higher tax rates

In the long run reduction in government
spending can lead to higher business
investment, that will replace this reduction.
Crowding Out Effect

The crowding out hypothesis:
government spending reduces private
investment. When government spends
people's money on public works projects
these funds simply crowd out private
investment.
Complete Crowding Out
Effect
C,I,G
E1
C + I + G1
C+I+G
C + I1+ G1
E
0
Q
Q1 QP
Q
Complete Crowding Out
Effect
 The government enacts a spending program,
increasing government spending on goods and
services from G to G1. As a result we have the
new C + I + G1 line. If there were no monetary
reaction, GNP would rise from Q to Q1.
Because of the monetary reaction, interest rates
rise and reduce investment to I1. The monetary
reaction is so powerful that the new spending
line is C + I1 + G1 with a new equilibrium level
of output, which is exactly the old equilibrium E.