Economics 12

Chapter 11 Fiscal Policy – Principles of Macroeconomics 6th Edition – Sayre and Morris

Economics 12[Economic Policy Making]

Fiscal Policy


A Question of RelevanceDo you remember what you were doing the evening

the last federal budget was unveiled in Parliament? Probably not. Furthermore, you quite likely think that "it has nothing to do with me." Yet, the truth is that government's annual budget affects you more than almost any other regularly scheduled event in your life, other than such personal events as birthdays and anniversaries. It determines the taxes you pay, the chances of your getting a job next summer, the likelihood of getting a student loan, and even the size of your classes next year.


Current News Canada budget unveiled Tuesday March

22, 2011 http://news.ph.msn.com/business/article.aspx?

cp-documentid=4720876 See Budget Home Page for details

http://www.budget.gc.ca/2011/home-accueil-eng.html


Fiscal Policy and the Budget Governments have to spend, therefore

they have to tax. What should government's attitude toward

its own spending and taxation be? How small or large should this spending and

taxation be? Should the two be equal? Does the condition of the economy have

anything to do with the answers to these questions?


Fiscal Policy and the Budget Fiscal policy is the government's

approach toward its own spending and taxation.

The minister of finance brings down the budget in Parliament each spring, revealing the government's fiscal policy for the coming year. Contains estimates of government's revenues

and expenditures.


Federal Budget Plan


Distribution of Revenues and Outlays


Some Definitions Net tax revenue (NTR) is the total tax revenue

received by government less transfer payments. Transfer payments are one-way transactions in which

payment is made but no good or service flows back in return – EI and CCP payments, subsidies to businesses

Government's budget balance is defined as the difference between net tax revenues and government spending NTR - G A positive balance means a budget surplus A negative balance means a budget deficit

The national debt, or, as it is sometimes called, the public debt, is the sum of the federal government’s budget deficits less its surpluses over some period of time.


Budget Surpluses/Deficits and the Net National Debt


From Deficit to Surplus What was behind the dramatic turnaround from

deficit to surplus? Government cut transfer payments to the provinces,

which squeezed the delivery of health care and higher education services across the country, with the result that waiting lists for surgery grew and hospitals closed beds, while college and university classes grew in size and professors' salaries were frozen.

Despite the cut in government spending, the rate of economic growth, fuelled by increased exports to the United States, accelerated and raised government revenues, since more people were working and paying income tax and total spending was up, which meant more GST revenue.


New Pressure Over Budget Surpluses What to do with the budget surpluses?

Some called for a dramatic increase in health and education spending, citing what they saw as a threat to the viability of Canada's health care system and a deterioration in the quality of higher education in the country.

Others wanted the surpluses to go to a reduction in the national debt, which they felt was simply too large.

A third group called for reductions in taxes, expressing concern over the growing gap in after-tax income between Canadians and Americans and evidence of a growing "braindrain" to the United States.

Perhaps not surprisingly, ministers of finance have subsequently brought down budgets that have done a little of all three.


Changes in the Economy Government Revenues Changes in the economy can have an

impact on government revenues. In general, net tax revenues are directly

related to the level of GDP.


Government Deficits and Surpluses


Government Deficits and Surpluses


How is the Government’s Budget Financed? It is financed by borrowing. When an individual buys a government bond

(such as a Canada Savings Bond or a treasury bill), she is, in effect, lending government some of her savings so that it can finance a deficit. Supply of money stays the same

Government can also borrow from the Bank of Canada. In this case, government would issue bonds and sell them to the Bank of Canada. Results in an injection of new money into the economy

(money supply is increased) Known as monetizing the debt

Not used to a great extent in Canada today. Has been frequently used by desperate governments in the

past to finance wars or to otherwise help a country survive extreme economic conditions.


Self Test


Stop Here for Today


Schools of Thought on Fiscal Policy What, if anything, should government do

when the economy faces unemployment or, for that matter, inflation? On the one hand we have economists and

policymakers, interventionists, who believe that government needs to deliberately intervene in the economy and overspend, or underspend, from time to time in order to help the economy achieve the goals of full employment and stable prices.

On the other hand, the noninterventionists believe that these goals can be achieved only if there is no government intervention.


Countercyclical Fiscal Policy Advocated by the interventionists, who start with the

premise that the modern market economy is unstable and thus prone to periods of unacceptably high levels of unemployment or inflation.

A policy used by governments in many countries around the world since World War II.

Main purpose is to close recessionary and inflationary gaps, that is, figuratively speaking, to lean against the prevailing winds. Weak aggregate demand with a recessionary gap, use

expansionary policy to deliberately stimulate demand with higher government spending or lower taxes (or both).

Strong aggregate demand with inflationary gap, use contractionary policy to dampen down demand through cuts in government spending or increases in taxes.


Countercyclical Fiscal Policy


Countercyclical Fiscal Policy


Countercyclical Fiscal PolicyIn summary, countercyclical fiscal policy means the

following: When aggregate demand is low and the economy

is experiencing a recessionary gap, governments should spend and tax in a way that increases aggregate demand.

When aggregate demand is high and an inflationary gap is present, governments should spend and tax in a way that reduces the level of aggregate demand.

In this way, government policy would be helping to stabilize the economy and take some of the sting out of the fluctuations in the business cycle.


Self Test


Criticisms of Countercyclical Fiscal Policy

The three criticisms of countercyclical fiscal policy are as follows:

it is subject to serious time lags it is ineffective because it may be

inflationary and crowds out private spending

it can cause serious budget deficits


Interventionists see the essence of countercyclical fiscal policy as that of fine-tuning the economy. Even if just the right amount of adjustment can

be determined, countercyclical fiscal policy takes time to implement and is slow to take effect. This means that the economy may suffer from an overdose of spending when the policy does take full effect.



It is ineffective because it may be inflationary, crowds out private spending, and thus reduces the size of the multiplier.





Criticisms of Countercyclical Fiscal Policy It ignores

the effect it has on govern-ment's budget.


Self Test


Stop Here for Today


Balanced-Budget Fiscal Policy Balanced-budget fiscal policy is the belief that a

government’s budget should be balanced in each budget period.

Advocates of a balanced-budget fiscal policy use three observations to support their position. countercyclical policy does more harm than good the economy has effective automatic stabilizers the economy is capable of returning to full-employment

equilibrium through a self-adjustment process


Criticisms of Balanced-Budget Fiscal Policy


Criticisms of Balanced-Budget Fiscal Policy Procyclical is the action by government that tends to push

the economy in the same direction it is leaning in. If the economy is experiencing a recessionary gap and a

budget deficit, then the pursuit of a balanced-budget fiscal policy will be procyclical. A recession implies unemployment. If the government takes

action to try to eliminate the budget deficit rather than the unemployment, then the level of unemployment will rise, since the level of GDP falls. The business cycle has created a given level of unemployment, and government's fiscal policy, which was aimed at reducing the deficit, resulted in even higher unemployment.

An inflationary gap is a result of high aggregate demand, which generates a level of income that is temporarily higher than the full-employment level of GDP. This generates sufficient tax revenue for government to be

running a budget surplus. Balanced-budget fiscal policy would then necessitate that either taxes be lowered or spending be increased to eliminate the budget surplus. This would raise aggregate demand and thus the level of GDP, increasing the size of the inflationary gap – again, procyclical.


Cyclically Balanced Budget Fiscal Policy Some economists suggest that governments should try to

balance the budget, not on an annual basis but over the life of the business cycle.

A typical business cycle can last for several years so that the use of fiscal policy to smooth out the business cycle would be viewed from a longer perspective than just each budget period.

In these circumstances, deficits might be big in some years, as the economy enters a recession, resulting in lower tax revenues and higher transfer payments. On the other hand, when the business cycle moves into an expansionary phase, the result should be budget surpluses.

This longer-view approach would continue to use countercyclical fiscal policy to lean against the prevailing winds, while addressing the concerns of many people about budget deficits and the size of the national debt.


Cyclically Balanced Budget Fiscal PolicyTwo potential problems with cyclically balanced

budget fiscal policy. No guarantee that the size and length of the

recessionary gap, when government is running a budget deficit, will be exactly offset by the size and length of the inflationary gap, when government is running a budget surplus. Result – the end of the business cycle may still show a

net budget deficit Political

Most governments find it easier to increase spending in bad times than to decrease it in good times.

Most business cycles are longer than the term of office of any particular government. This invites the existing government to leave the problem of balancing the budget to the succeeding government.


Just how big is our national debt?

It certainly seems like a "staggering" increase. But since the population of Canada has increased appreciably during the past hundred years, it might be better to show the figures in terms of per capita debt, as in Table 11.4.


Just how big is our national debt?

So the average debt per person has increased from a mere $254 in 1926 to over $15 000 eighty years later. It certainly looks like a fairly staggering increase. But we need to make one further adjustment to allow for the effects of inflation over the years. So, let us show the total debt, but this time, in constant 2002 dollars, as in Table 11.5.


Just how big is our national debt? Finally, let us combine both factors in Table 11.6

to give us figures in terms of constant dollars per capita.

This puts things in perspective. In real terms, the per capita debt increased 32 percent in the 14 years leading up to World War II; it more than tripled during the war, declined to less than half by 1967, but has more than tripled in the last 40 years.


Just how big is our national debt? The best measure of the size of any debt is

relative to the ability to repay, and this is relative to income. Table 11.7 shows the size of Canada's debt relative to the country's income, that is, as a percentage of GDP (of GNP till 1967).


Just how big is our national debt? Major causes of the growth of Canada's

debt Financing of World War II Deficit financing to prevent or escape from a

recession Financing of necessary infrastructure, such as

bridges and airports Increase in the size of income-support

programs. (especially since the early 1970s) Very high interest rates between the mid-

1970s and the 1990s have compounded the size of the debt.


Problems of the National Debt: Fact or Fantasy?The problems with high deficits and debt are as

follows: the potential crowding out of private investment

spending and net exports the interest payments that must be paid on the

foreign-held debt the income redistribution effects of large interest

payments the reduced ability of government to meet the

needs of its citizens the possible increased greed and wastefulness of

government


A Few Other Notes A federal government cannot go broke as a result of

internal borrowing. A federal government, which has unlimited powers of taxation and borrowing, has direct control over the nation's supply of money.

A big national debt suggests we are encumbering future generations. It is true that our children and grandchildren will inherit a larger debt and the interest charges associated with it. However, it is also true that future generations will inherit the Canadian-held portion of the assets (bonds) represented by that debt.

Federal government is in debt hundreds of billions of dollars, but it also owns assets – airports, military hardware, land, buildings, and so on – that total a great deal.

Most observers suggest that a debt/GDP ratio of less than 50 percent is not particularly worrisome.


In Summary Budget deficits when the economy is

otherwise strong can be inflationary, while budget surpluses can make a weak economy even weaker.

Accepting deficits as a way of life regardless of the state of the economy is as dangerous for a government as single-mindedly attempting to reduce the national debt while ignoring other more important economic goals.


Self Test

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Economics 12