The objectives of fiscal policy

Governments can use fiscal policy as a demand-side policy to achieve their macroeconomic objectives in a similar way to the application of monetary policy. Fiscal policy involves governments using tax and government expenditure to achieve macroeconomic objectives. The tools of fiscal policy can be used to target the following objectives:

• Sustainable economic growth
• Low unemployment
• External balance on the current account balance of payments
• Low inflation or price stability
• Achievement of a more equitable distribution of income

Sources of government revenue

The government can access revenue to fund its expenditure from the following sources:

• Direct taxation on household incomes in the form of income tax and tax on business profits in the form of corporation tax.
• Indirect taxation such as VAT and specific duties on goods and services.
• Profit from the operations of state-run organisations. Many governments own organisations in the transport and energy sectors and make a profit from them.
• Asset sales when governments privatise industries. When governments sell the assets of state-owned enterprises it leads to an inflow of funds to the state.

Government borrowing

Government borrowing is an important part of fiscal policy because it is needed when government expenditure is greater than taxation. Government borrowing is financed by selling bonds in the financial markets. For example, the Indian government might sell $200 billion of government bonds to raise $200 billion in funds to spend on health, education and defence, etc.

The budget deficit is one year’s government borrowing. The current Indian budget deficit is $137 billion.

The national debt is accumulated government borrowing over time. The current Indian national debt is $2219 billion.

Types of government expenditure

There are three types of government expenditure:

• Current expenditure on the day-to-day running of the government sector such as paying the wages of teachers, doctors and military personnel.
• Capital expenditure on investment projects financed by the government such as building roads, bridges and schools.
• Transfer expenditure on welfare payments such as unemployment and housing benefits.

The influence of the Keynesian multiplier on fiscal policy (HL only)

The application of fiscal policy by governments is affected by the Keynesian multiplier. This is because the application of fiscal policy in an economy involves changing injections into the circular flow of income in the form of government expenditure and withdrawals out of the circular flow of income in the form of taxation.

Defining the multiplier

The government expenditure multiplier is the ratio of change in government expenditure to a change in national income. A multiplier effect occurs when a change in injections brings about a greater proportionate change in national income. The multiplier can occur because of a change in any one of the injections into the circular flow of income: investment(I), government expenditure (G) and exports (X).

The multiplier can be measured as the ratio of change in any one of these injections (J) to a change in national income (Y).

multiplier = change in national income / change in injections

The government expenditure multiplier involved with fiscal policy would be:

government expenditure multiplier = change in national income / change in government expenditure

Multiplier situations occur when funds are injected into the circular flow of income through investment, government expenditure and exports and this leads to a greater final change in the value of the national income than the value of the change in the injection.  Diagram 3.31 shows the circular flow of income with injections (I, G and X) and withdrawals (S, T and M).  The increase in injections causes a multiplier effect to take place, but the strength of the multiplier is determined by the level of consumption and the withdrawals from the circular flow, savings, tax and imports. For example, an increase in government expenditure will cause an increase in national income which will lead to a rise in consumption by households and also a rise in the amount saved, paid in tax and spent on imports. 

Calculating the value of the multiplier

The value of the multiplier can be calculated by using the following equations:

Multiplier = 1/(1-MPC) or 1/(MPS+MPT+MPM)

Marginal propensity to consume (MPC)

This is the proportionate change in consumption brought about by a change in income.  It is calculated using the equation:

MPC = ∆C/∆Y 

If household income rises from $10,000 and consumption rises by $6,000 then the MPC will be:

+$6,000 / +$10,000 = 0.6

Marginal propensity to save (MPS)

This is the proportionate change in saving brought about by a changing income. It Is calculated using the equation:

MPS = ∆S/∆Y  

If household income rises by $10,000 and savings rise by $500 then the MPS will be:

+$500 / +$10,000 = 0.05

Marginal propensity to tax (MPT)

This is the proportionate change in tax brought about by a changing income. It Is calculated using the equation:

MPT = ∆T/∆Y 

If household income rises by $10,000 and tax rises by $2,000 then the MPT will be:

+$2,000 / +$10,000 = 0.20

Marginal propensity to imports (MPM)

This is the proportionate change in imports brought about by a changing income. It Is calculated using the equation:

MPM = ∆M/∆Y 

If household income rises by $10,000 and imports rise by $1,500 then the MPM will be:

+$1,500 / +$10,000 = 0.15

Calculation

In this case, the value of the multiplier would be:

1 / 0.05 + 0.20 + 0.15 = 2.5

Example of the multiplier

The multiplier process can be explained using the following example where the government decides to spend $2 billion building a new bridge as part of the improvement in the infrastructure of a region of the country. 

These are the stages of the multiplier effect brought about by the rise in government expenditure:

Stage 1: $2Bn is paid to factors of production to build the new bridge. This will partly be wages paid to labour who work directly on the construction of the bridge. Funds will also be paid to firms that supply construction equipment, raw materials, and services like law and architects. These payments will generate income for the workers and for the owners of the businesses that supply factors of production to build the bridge. 

Stage 2 The $2Bn income paid to the factors of production to build the bridge will be partly spent as consumption expenditure, and the rest will be leaked out of the economy in the form of savings, tax and imports.  The size of the extra income consumed depends on the MPC of the economy, and the amount leaked depends on the MPS, MPT and MPM of the economy.  In our example, the MPC is 0.6, so $1.2Bn will be consumption expenditure, and the MPW is 0.4, so $0.8Bn will be withdrawn from the economy as savings, tax and imports.

Stage 3 The $1.2Bn of consumption spending by households will be on buying goods and services produced by firms and this will become income for the factors of production employed by these firms.  The households that receive the $1.2Bn of income will spend part of this income (0.6 x $1.2Bn = $0.72Bn) on consumption and the rest will be withdrawn (0.4 x $1.2Bn = $0.48Bn) from the economy as savings, tax and imports.

Stage 4 The $0.72Bn is another spending round that works in the same way as the previous spending rounds with income to households, which is partly spent on consumption and partly withdrawn out of the economy. This process continues with each spending round getting smaller and smaller until they no longer add to the total national income.

Stage 5 The flow chart shows how adding together the income generated by each spending round gives us the final change in national income.

Calculating the final change in national income

The final change in national income in this example is calculated using the equation 1/1-MPC or 1/MPS + MPT + MPM

In this case:

• MPS = 0.05
• MPT = 0.20
• MPM = 0.15

1/0.05 + 0.20 + 0.15 = 2.5

The final change in national income brought about by the $2 billion government expenditure on the bridge is calculated as:

2.5 x $2Bn = $5Bn

The final change in national income resulting from the government expenditure of $2 billion on the bridge is $5 billion.

Graphical interpretation of the multiplier

When there is an increase in injections into the economy aggregate demand in the economy increases. In our example, when the government spends $2 billion on the bridge, aggregate demand in the economy initially increases from AD to AD1 in diagram 3.32. The additional spending rounds cause aggregate demand to increase further and the final change in aggregate demand is at AD2 in diagram 3.32.

Evaluation of the multiplier

The Keynesian multiplier has strengths and weaknesses when it is applied to the economy.

Strengths of the multiplier

• It is useful for building economic models and analysing how changes in national income are affected by changes in government expenditure, investment, and exports.
• The multiplier can be used to improve economic forecasting.
• The government can use the multiplier to analyse the impact of a change in government spending across the whole economy and at a local level.

Weaknesses of the multiplier

• The marginal propensities to consume, save, tax, and import can be difficult to measure and can change over time, making establishing a multiplier value difficult.
• Isolating the impact of a change of one item of expenditure is difficult to do because different items of expenditure are all changing at the same time. The government might be spending funds on a new bridge at the same time as firms are investing in new factories.
• Many expenditure projects take place over a long period, so expenditures gradually enter the economy rather than as one sum at a time. For example, the $2 billion of government expenditure on the bridge might take several years to be spent.

Expansionary fiscal policy

Expansionary fiscal is where the government decreases taxation and increases government spending to increase aggregate demand. For example, the US government has agreed to a $2 trillion increase in expenditure to deal with the fall in economic growth caused by the COVID-19 crisis.

How the policy works

As a component of aggregate demand, an increase in government expenditure will directly increase aggregate demand. Cutting direct and indirect tax will increase consumption as households have more disposable income to increase their spending and firms have more profit to fund increased investment. As consumption and investment increase, aggregate demand increases.

Diagram 3.33 shows how an increase in aggregate demand will shift AD to AD1 leading to an increase in national income from Y to YFE and the average price level increases from P to P1. The rise in national income also closes the deflationary gap. The rise in national income can increase the rate of economic growth and reduce unemployment.  

The flow cha

rt shows the transmission mechanism of expansionary fiscal policy.

Increased employment

As aggregate demand increases, there is a rise in real GDP, which means businesses might produce more and employ more workers to do this. This is illustrated in the labour market diagram, where the demand for labour increases from ADL to ADL1, and the rise in employment reduces unemployment.

Fiscal policy and crowding out (HL)

An issue with expansionary fiscal policy is the impact it can have on interest rates in the financial markets.  An expansionary fiscal policy can lead to an increase in the budget deficit that in turn leads to a rise in money market interest rates. This makes financing a budget deficit more difficult and can make borrowing costs increase throughout the economy.  The crowding out process associated with an expansionary fiscal policy can be summarised in the following way:

• Stage 1 - Expansionary fiscal policy leads to a budget deficit.
• Stage 2 - The government sells bonds in the money markets to fund the deficit.
• Stage 3 - The government needs to make the bonds attractive to buyers, which means increasing the rate of interest paid on the bonds, which pushes up market interest rates.
• Stage 4 - As the government borrows more, there is a higher demand for borrowed funds in the money markets, which also pushes up market interest rates
• Stage 5 - Higher market interest rates reduce consumption and investment, and this leads to a fall in aggregate demand.

• Stage 6 - Where expansionary fiscal policy means higher government borrowing in the money markets, this is seen as a situation where public sector spending ‘crowds out’ private sector spending. 

  

Credit rating

Credit rating agencies, such as Moody's and Standard and Poor, can also look unfavourably on expansionary fiscal policy when it leads to an increase in the budget deficit. These agencies make judgements about the security of government borrowing.

Credit rating agencies may view very large government deficits unfavourably and downgrade the government's credit rating, which causes the money markets to charge higher interest rates to the government because it appears to be a greater risk. This happened to Greece and Spain in 2012 when they increased their budget deficits following the global financial crisis.

Evaluation of expansionary fiscal policy

Strengths

• Fiscal policy is most appropriate for demand-deficient unemployment in a recession, where the fall in aggregate demand has caused a rise in unemployment, and expansionary fiscal policy increases aggregate demand.
• Increasing government expenditure and reducing taxation have a direct impact on the economy. Cutting taxation directly increases consumer incomes, and an increase in government expenditure directs increases aggregate demand as it is one of the components of aggregate demand.
• Fiscal policy does not affect the exchange rate in the way monetary policy does when interest rates are changed. A decrease in interest rates when an expansionary monetary policy is applied causes a country’s exchange rate to depreciate, and this will not happen with an expansionary fiscal policy.

Weaknesses

• Cutting taxes and increasing government spending will increase a country’s budget deficit and national debt. This may be particularly difficult for a government with an already-existing budget deficit because the economy is in a recession, government transfer spending rises, and tax revenues fall.
• Crowding out of the private sector by public sector spending when a government budget deficit increases market interest rates.
• Some economists question the effectiveness of tax cuts in a recession.  Tax cuts rely on households spending the extra disposable income they receive, and they may save it when they are fearful of spending in a recession when households are uncertain about their employment.
• Increasing government spending may lead to an inefficient use of resources.  Government spending on projects just for the sake of spending may mean resources are used to improve roads that do not need improving or money gets lost in the bureaucracy associated with government expenditure projects.
• Fiscal policy lacks flexibility because the government can only change tax and expenditure a certain number of times each year.  The process of changing tax, for example, is difficult because firms and households need to be told of the proposed changes and they have to be worked through by the tax authorities.
• Increasing aggregate demand through expansionary fiscal policy may lead to a rise in inflation. This is particularly true if the policy is used when unemployment is not that high and is not caused by falling aggregate demand. The economy could be operating at full employment and expansionary fiscal policy just leads to inflation.
• Expansionary fiscal policy will only really tackle demand-deficient unemployment. It fails with other types of unemployment, such as structural and frictional unemployment, because they are not directly caused by falling aggregate demand. 

Contractionary fiscal policy

How contractionary fiscal policy reduces inflation

A contractionary fiscal policy is where the government increases taxation and decreases government expenditure to reduce inflation and close an inflationary gap.  A rise in taxation will reduce consumption if household income taxes rise and reduce investment if business taxes are increased. An increase in tax combined with a decrease in government spending leads to a fall in aggregate demand.  This is shown in diagram 3.35, where AD shifts to AD1, which leads to a decrease in the average price level and inflation falls. There is also a decrease in real GDP from Y to YFE and the inflationary gap is closed.

The flow

diagram shows the transmission mechanism of contractionary fiscal policy.

Evaluation of contractionary fiscal policy

Strengths

• Fiscal policy does not rely on a transmission mechanism in the same way monetary policy does and has a more direct effect on aggregate demand. For example, increasing taxation will directly decrease household income, whereas an increase in interest rates relies on the banking system passing the increased interest rate on to households.
• Because fiscal policy has a more direct effect on the economy compared to monetary policy there is a shorter time lag associated with the use of contractionary fiscal policy compared to monetary policy.
• Changing tax and government expenditure does not affect a country’s exchange rate in the way a change in interest rates can change a country’s exchange rate. Contractionary monetary policy means increasing interest rates which can lead to appreciation in the exchange rate.
• Fiscal policy can be targeted more specifically at different sectors of the economy to reduce inflation. For example, reducing indirect tax will directly reduce the price of goods and services.

Weakness

• Raising taxes may have a negative impact on the motivation of workers and entrepreneurs because of the potential reduction in their income. Reduced incentives might have a negative effect on the supply side of the economy if, for example, entrepreneurs are less likely to start businesses because of higher taxation.
• Higher indirect taxes can add to business costs, and higher direct taxes on workers might mean they ask for higher wages to make up for their reduction in income. Higher business costs may increase cost-push inflation.
• Reducing government expenditure and increasing taxation can lead to austerity which has a negative effect on welfare in society. For example, reducing government expenditure may mean reducing the quality of public services like education and healthcare.
• Fiscal policy lacks flexibility because it is difficult to change tax rates and government expenditure more than a certain number of times a year. On the other hand, interest rates can be changed much more regularly.
• Increasing taxes and cutting government expenditure can lead to a fall in aggregate demand, which reduces the rate of economic growth and could even lead to a recession and rising unemployment.

Automatic stabilisers (HL)

Automatic stabilizers are a part of fiscal policy and occur because tax and government expenditure automatically change during the business cycle, and this has consequences of inflationary and deflationary gaps.

Inflationary gap

The boom phase of the business cycle may lead to an inflationary gap in an economy where inflation rises. Automatic stabilisers can reduce the strength of the inflationary effect in the following ways:

• Direct tax rises in the economy because household income and business profits increase.

• Government expenditure falls because there is less transfer spending on benefits such as unemployment payments.

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Diagram 3.36 shows how the rise in tax and fall in government expenditure causes aggregate demand to fall from AD1 to AD2 when the automatic stabiliser starts to work when there is an inflationary gap.

Deflationary gap

In the recession phase of the business cycle, there may be a deflationary gap and a rise in unemployment. Automatic stabilisers can reduce the strength of the deflationary effect in the following way:

• The amount of direct tax falls as household incomes fall and firms make lower profits. Indirect tax also falls as households spend less.

• Government expenditure on benefits increases as unemployment rises, and the government pays more unemployment and related benefits.

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Diagram 3.37 shows how the fall in tax and rise in government expenditure causes aggregate demand to rise from AD1 to AD2 when the automatic stabiliser takes effect when there is a deflationary gap.