Fiscal Policy

Fiscal Policy
in the
Philippines

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What is Fiscal Policy?

Fiscal policy refers to the "measures employed by governments to

stabilize the economy, specifically by manipulating the levels and
allocations of taxes and government expenditures.

Fiscal measures are frequently used in tandem with monetary policy to

achieve certain goals. In the Philippines, this is characterized by
continuous and increasing levels of debt and budget deficits, though
there have been improvements in the last few years.

The Philippine government’s main source of revenue are taxes, with

some non-tax revenue also being collected. To finance fiscal deficit and
debt, the Philippines relies on both domestic and external sources.

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Fiscal policy during the Marcos administration was primarily focused on

indirect tax collection and on government spending on economic
services and infrastructure development.

The first Aquino administration inherited a large fiscal deficit from the

previous administration, but managed to reduce fiscal imbalance and
improve tax collection through the introduction of the 1986 Tax Reform
Program and the value added tax.

The Ramos administration experienced budget surpluses due to

substantial gains from the massive sale of government assets and strong
foreign investment in its early years. However, the implementation of the
1997 Comprehensive Tax Reform Program and the onset of the Asian
financial crisis resulted to a deteriorating fiscal position in the
succeeding years and administrations.

The Estrada administration faced a large fiscal deficit due to the decrease

in tax effort and the repayment of the Ramos administration’s debt to
contractors and suppliers.

During the Arroyo administration, the Expanded Value Added Tax Law

was enacted, national debt-to-GDP ratio peaked, and under spending on
public infrastructure and other capital expenditures was observed.

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Revenues and Funding

A comparative graph of Revenue and Tax Effort from 2001-2010

A comparative graph of Tax and Non-Tax Revenue contribution from

2001-2010
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The Philippine government generates revenues mainly through personal

and income tax collection, but a small portion of non-tax revenue is also
collected through fees and licenses, privatization proceeds and income
from other government operations and state-owned enterprises.

 Tax Revenue

Tax collections comprise the biggest percentage of revenue

collected. Its biggest contributor is the Bureau of Internal
Revenue (BIR), followed by the Bureau of Customs (BOC). Tax
effort as a percentage of GDP has averaged at roughly 13% for the
years 2001-2010.

 Income Taxes

Income tax is a tax on a person's income, wages, profits arising

from property, practice of profession, conduct of trade or business
or any stipulated in the National Internal Revenue Code of 1997
(NIRC), less any deductions granted. Income tax in the Philippines
is a progressive tax, as people with higher incomes pay more than
people with lower incomes. Personal income tax rates vary as such:

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Annual Taxable Income Income Tax Rate

Less than P10,000 5%

Over P10,000 but not over P30,000 P500 + 10% of the excess over P10,000

Over P30,000 but not over P70,000 P2,500 + 15% of the excess over P30,000

Over P70,000 but not over P140,000 P8,500 + 20% of the excess over P70,000

Over P140,000 but not over P250,000 P22,500 + 25% of the excess over P140,000

Over P250,000 but not over P500,000 P50,000 + 30% of the excess over P250,000

Over P500,000 P125,000 + 32% of the excess over P500,000

The top rate was 35% until 1997, 34% in 1998, 33% in 1999, and 32%
since 2000.

In 2008, Republic Act No. 9504 (passed by then-President Gloria

Macapagal-Arroyo) exempted minimum wage earners from paying
income taxes.

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 E-VAT
The Expanded Value Added Tax (E-VAT), is a form of sales tax that
is imposed on the sale of goods and services and on the import of
goods into the Philippines. It is a consumption tax (those who
consume more are taxed more) and an indirect tax, which can be
passed on to the buyer. The current E-VAT rate is 12% of
transactions. Some items which are subject to E-VAT include
petroleum, natural gases, indigenous fuels, coals, medical services,
legal services, electricity, non-basic commodities, clothing, non-
food agricultural products, domestic travel by air and sea.

The E-VAT has exemptions which include basic commodities and socially
sensitive products. Exemptible from the E-VAT are:

1. Agricultural and marine products in their original state (e.g.

vegetables, meat, fish, fruits, eggs and rice), including those which
have undergone preservation processes (e.g. freezing, drying,
salting, broiling, roasting, smoking or stripping);

2. Educational services rendered by both public and private

educational institutions;

3. Books, newspapers and magazines;

4. Lease of residential houses not exceeding P10,000 monthly;

5. Sale of low-cost house and lot not exceeding P2.5 million

6. Sales of persons and establishments earning not more than P1.5

million annually.

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 Tariffs and Duties

Second to the BIR in terms of revenue collection, the Bureau of
Customs (BOC) imposes tariffs and duties on all items imported
into the Philippines. According to Executive Order 206, returning
residents, Overseas Filipino Workers (OFW’s) and former Filipino
citizens are exempted from paying duties and tariffs.

 Non-Tax Revenue
Non-tax revenue makes up a small percentage of total government
revenue (roughly less than 20%), and consists of collections of fees
and licenses, privatization proceeds and income from other state
enterprises.

 The Bureau of Treasury

The Bureau of Treasury (BTr) manages the finances of the
government, by attempting to maximize revenue collected and
minimize spending. The bulk of non-tax revenues comes from the
BTr’s income. Under Executive Order No.449, the BTr collects
revenue by issuing, servicing and redeeming government
securities, and by controlling the Securities Stabilization Fund
(which increases the liquidity and stabilizes the value of
government securities) through the purchase and sale of
government bills and bonds.

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 Privatization
Privatization in the Philippines occurred in three waves: The first
wave in 1986-1987, the second during 1990 and the third stage,
which is presently taking place. The government’s Privatization
Program is handled by the inter-agency Privatization Council and
the Privatization and Management Office, a sub-branch of the
Department of Finance.

 PAGCOR
The Philippine Amusement and Gaming Corporation (PAGCOR) is a
government-owned corporation established in 1977 to stop illegal
casino operations. PAGCOR is mandated to regulate and license
gambling (particularly in casinos), generate revenues for the
Philippine government through its own casinos and promote
tourism in the country.

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Spending, Debt, and Financing

Government Spending and Fiscal Imbalance

In 2010, the Philippine Government spent a total of P1.5 trillion and

earned a total of P1.2 trillion from tax and non-tax revenues, thus
resulting to a total deficit of P314.5 billion.

Despite the national deficit of the Philippines, the Department of

Finance reported an average of P29.6 billion in Local Government Unit
(LGU) surplus, which is mostly due to an improved LGU financial
monitoring system which the government implemented in the recent
years. Efforts of the monitoring system include "debt monitoring and
creditworthiness monitoring system, effective mobilization of second
generation funds (SGF) to promote LGU development, and the
implementation of a Land Administration and Management Project
(LAMP2) which received a 'very good' rating from the World Bank (WB)
and Australian Agency for International Development (AusAid)."

Microfinance management in the Philippines is improving substantially.

In 2009, the Economist Intelligence Unit "recognized the Philippines as
the best in the world in terms of its microfinance regulatory framework."
The DOF-National Credit Council (DOF-NCC) focused on improving the
state of local cooperatives by developing a supervision and examination
manual, launching advocacies for these cooperatives, and pushing for the

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Philippine Cooperative Code of 2008. A standardized national strategy

for micro insurance and the provisions of grants and technical assistance
were formulated.

A comparative graph of National Revenues and Expenditures from

2001-2010

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A comparative graph of Domestic and External Sources of Financing

from 2001-2010

A comparative graph of Total National Debt from 2001-2010

Financing and Debt

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Aside from Tax and Non-Tax Revenues, the government makes use
of other sources of financing to support its expenses. In 2010, the
government borrowed a total net of P351.646 billion for financing :

Domestic External
Sources Sources

Gross Financing P489.844 billion P257.357 billion

Less:
P271.246 billion P124.309 billion
Repayments/Amortization

Net Financing P218.598 billion P133.048 billion

Total Financing P351.646 billion

External Sources of Financing are:

1. Program and Project Loans - the government offers project loans to

external bodies and uses the proceeds to fund domestic projects
like infrastructure, agriculture, and other government projects.[20]

2. Credit Facility Loans

3. Zero-coupon Treasury Bills

4. Global Bonds

5. Foreign Currencies

Domestic Sources of Financing are:

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1. Treasury Bonds

2. Facility loans

3. Treasury Bills

4. Bond Exchanges

5. Promissory Notes

6. Term Deposits

In 2010, the total outstanding debt of the Philippines reached P4.718

trillion: P2.718 trillion from outstanding domestic sources and P2 trillion
from foreign sources. According to the Department of Finance, the
country has recently reduced dependency on external sources to
minimize the risks caused by changes in the global exchange rates.
Efforts to reduce national debt include increasing tax efforts and
decreasing government spending. The Philippine government has also
entered talks with other economic entities, like the ASEAN Finance
Ministers Meeting (AFMM), ASEAN+3 Finance Ministers Meeting
(AFMM+3), Asia-Pacific Economic Cooperation (APEC), and ASEAN
Single-Window Technical Working Group (ASW-TWG), in order to
strengthen the countries' and the region's debt management efforts

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History of Philippine Fiscal Policy

 Marcos Administration (1981-1985)

The tax system under the Marcos administration was generally

regressive as it was heavily dependent on indirect taxes. Indirect taxes
and international trade taxes accounted for about 35% of total tax
revenue, while direct taxes only accounted for 25%. Government
expenditure for economic services peaked during this period, focusing
mainly on infrastructure development, with about 33% of the budget
spent on capital outlays. In response to the higher global interest rates
and to the depreciation of the peso, the government became increasingly
reliant on domestic financing to finance fiscal deficit. The government
also started liberalizing tariff policy during this period by enacting the
initial Tariff Reform Program, which narrowed the tariff structure from a
range of 100%-0% to 50%-10%, and the Import Liberalization Program,
which aimed at reducing or eliminating tariffs and realigning indirect
taxes.

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 Aquino Administration (1986-1992)

Faced with problems inherited from the previous administration, the

most important of which being the large fiscal deficit heightened by the
low tax effort due to a weak tax system, Aquino enacted the 1986 Tax
Reform Program (TRP). The aim of the TRP was to “simplify the tax
system, make revenues more responsive to economic activity, promote
horizontal equity and promote growth by correcting existing taxes that
impaired business incentives”. One of the major reforms enacted under
the program was the introduction of the Value Added Tax (VAT), which
was set at 10%. The 1986 tax reform program resulted in reduced fiscal
imbalance and higher tax effort in the succeeding years, peaking in 1997,
before the enactment of the 1997 Comprehensive Tax Reform Program
(CTRP). The share of non-tax revenues during this period soared due to
the sale of sequestered assets of President Marcos and his cronies
(totalling to about ₱20 billion), the initial efforts to deregulate the oil
industry and thrust towards the privatization of state enterprises. Public
debt servicing and interest payments as a percent of the budget peaked
during this period as government focused on making up for the debt
incurred by the Marcos administration. Another important reform
enacted during the Aquino administration was the passage of the 1991
Local Government Code which enabled fiscal decentralization. This
increased the taxing and spending powers to local governments in effect
increasing local government resources.

 Ramos Administration (1993-1998)

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The Ramos administration had budget surpluses for four of its six years in

power. The government benefited from the massive sale of government assets
(totaling to about P70 billion, the biggest among the administrations) and
continued to benefit from the 1986 TRP. The administration invested heavily
on the power sector as the country was beset by power outages. The
government utilized its emergency powers to fast-track the construction of
power projects and established contracts with independent power plants.
This period also experienced a real estate boom and strong foreign direct
investment to the country during the early years of the administration, in
effect overvaluing the peso. However, with the onset of the Asian financial
crisis, the peso depreciated by almost 40%. The Ramos administration relied
heavily on external borrowing to finance its fiscal deficit but quickly switched
to domestic dependence on the onset of the Asian financial crisis. The
administration has been accused of resorting to “budget trickery” during the
crisis: balancing assets through the sales of assets, building up accounts
payable and delaying payment of government premium to social security
holders. In 1997, the Comprehensive Tax Reform Program (CTRP) was
enacted. Republic Act (RA) 8184 and RA 8240, which were implemented
under the program, were estimated to yield additional taxes of around P7.4
billion; however, a decline in tax effort during the succeeding periods was
observed after the CTRP was implemented. This was attributed to the
unfavorable economic climate created by the Asian fiscal crisis and the poor
implementation of the provisions of the reform. A sharp decrease in
international trade tax contribution to GDP was also observed as a
consequence of the trade liberalization and globalization efforts in the 1990s,
more prominently, the establishment of the ASEAN Free Trade Agreement
(AFTA) and membership to the World Trade Organization (WTO) and
the Asia-Pacific Economic Cooperation (APEC). The Ramos administration
also provided additional incentives to export-oriented firms, the most
prominent among these being RA 7227 which was instrumental to the success
of the Subic Bay Freeport Zone.

 Estrada Administration (1999-2000)

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President Estrada, who assumed office at the height of the Asian financial

crisis, faced a large fiscal deficit, which was mainly attributed to the sharp
deterioration in the tax effort (as a result of the 1997 CTRP: increased tax
incentives, narrowing of VAT base and lowering of tariff walls) and higher
interest payments given the sharp depreciation of the peso during the crisis.
The administration also had to pay P60 billion worth of accounts payables left
unpaid by the Ramos administration to contractors and suppliers. Public
spending focused on social services, with spending on basic education
reaching its peak. To finance the fiscal deficit, Estrada created a balance
between domestic and foreign borrowing.

 Arroyo Administration (2002-2009)

The Arroyo administration’s poor fiscal position was attributed to weakening

tax effort (still resulting from the 1997 CTRP) and rising debt servicing costs
(due to peso depreciation). Large fiscal deficits and heavy losses for
monitored government corporations were observed during this period.
National debt-to-GDP ratio reached an all-time high during the Arroyo
administration, averaging at 69.2%. Investment in public infrastructure (at
only 1.9% of GDP), expenditure for economic services, health spending and
education spending all hit an historic-low during the Arroyo administration.
The government responded to its poor fiscal position by under-spending in
public infrastructure and social overhead capital (education and health care),
thus sacrificing the economy’s long-term growth. In 2005, RA 9337 was
enacted, the most significant amendments of which were the removal of
electricity and petroleum VAT exemptions and the increase in the VAT rate
from 10% to 12%.

ROLE OF FISCAL POLICY

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Fiscal policy is the use of government revenue (taxes) and expenditure

(spending) to influence the economy, and meet the macroeconomic
goals.

The government’s revenue and expenditure form its budget. If the

revenue collection in the form of taxes equals its expenditure, it’s a
balanced budget. If revenue exceeds expenditure, the government has a
budget surplus. On the other hand, if expenditure exceeds revenue, it’s a
budget deficit.

A government follows a neutral fiscal policy when the economy is in

equilibrium. In such a case, the government’s expenditure is fully funded
by the tax revenue. A government follows expansionary fiscal policy
during times of recession. It may reduce taxes or increase expenditure in
order to stimulate the economy – to increase demand, growth and
employment.  The government may follow contractionary fiscal policy to
reduce fiscal deficit or pay down government debt. To do so, it may
increase taxes or decrease expenditure, which will decrease demand,
growth and employment.

Fiscal policy is based on Keynesian economics, which believes that the

government can influence the macroeconomic productivity levels by
changing the taxes and spending. Such influence can curb inflation,
increase employment rate, and stabilize the value of money. Monetarists,
however, believe that the effects of fiscal policy are only temporary, and
they advocate use of monetary policy to control inflation.

Fiscal policy can be discretionary or nondiscretionary (automatic

stabilizers). A discretionary fiscal policy refers to the deliberate changes
in government spending and taxes in order to stabilize the economy; for
example, the government decides to increase its capital expenditure on
road infrastructure. On the other hand, automatic stabilizers are the
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automatic changes in the tax and spending levels because of the changes
in economic conditions. They help stabilize business cycles. For example,
when the economy is expanding, the tax revenue increases, and vice
verse. There will also be lower government spending in the form of
unemployment benefits. Economists have observed that automatic
stabilizers can reduce the volatility of the economic cycle by up to 20%.

How Fiscal Policy Works?

Fiscal policy is based on the theories of British economist John Maynard

Keynes. Also known as Keynesian economics, this theory basically states
that governments can influence macroeconomic productivity levels by
increasing or decreasing tax levels and public spending. This influence, in
turn, curbs inflation (generally considered to be healthy when between
2-3%), increases employment and maintains a healthy value of money.
Fiscal policy is very important to the economy. For example, in 2012
many worried that the fiscal cliff, a simultaneous increase in tax rates
and cuts in government spending set to occur in January 2013, would
send the U.S. economy back to recession. The U.S. Congress avoided this
problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1,
2013.

Balancing Act

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The idea, however, is to find a balance between changing tax rates and
public spending. For example, stimulating a stagnant economy by
increasing spending or lowering taxes runs the risk of causing inflation
to rise. This is because an increase in the amount of money in the
economy, followed by an increase in consumer demand, can result in a
decrease in the value of money - meaning that it would take more money
to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are
up, consumer spending is down and businesses are not making
substantial profits. A government thus decides to fuel the economy's
engine by decreasing taxation, which gives consumers more spending
money, while increasing government spending in the form of buying
services from the market (such as building roads or schools). By paying
for such services, the government creates jobs and wages that are in turn
pumped into the economy. Pumping money into the economy by
decreasing taxation and increasing government spending is also known
as "pump priming." In the meantime, overall unemployment levels will
fall.

With more money in the economy and fewer taxes to pay, consumer
demand for goods and services increases. This, in turn, rekindles
businesses and turns the cycle around from stagnant to active.

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If, however, there are no reins on this process, the increase in economic
productivity can cross over a very fine line and lead to too much money
in the market. This excess in supply decreases the value of money while
pushing up prices (because of the increase in demand for consumer
products). Hence, inflation exceeds the reasonable level.

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For this reason, fine tuning the economy through fiscal policy alone can
be a difficult, if not improbable, means to reach economic goals. If not
closely monitored, the line between a productive economy and one that
is infected by inflation can be easily blurred.

And When the Economy Needs to Be Curbed…

When inflation is too strong, the economy may need a slowdown. In such
a situation, a government can use fiscal policy to increase taxes to suck
money out of the economy. Fiscal policy could also dictate a decrease in
government spending and thereby decrease the money in circulation. Of
course, the possible negative effects of such a policy in the long run could
be a sluggish economy and high unemployment levels. Nonetheless, the
process continues as the government uses its fiscal policy to fine-tune
spending and taxation levels, with the goal of evening out the business
cycles.

Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same for

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everyone. Depending on the political orientations and goals of the

policymakers, a tax cut could affect only the middle class, which is
typically the largest economic group. In times of economic decline and
rising taxation, it is this same group that may have to pay more taxes
than the wealthier upper class.

Similarly, when a government decides to adjust its spending, its policy

may affect only a specific group of people. A decision to build a new
bridge, for example, will give work and more income to hundreds of
construction workers. A decision to spend money on building a new
space shuttle, on the other hand, benefits only a small, specialized pool of
experts, which would not do much to increase aggregate employment
levels.

The Bottom Line

One of the biggest obstacles facing policymakers is deciding how much

involvement the government should have in the economy. Indeed, there
have been various degrees of interference by the government over the
years. But for the most part, it is accepted that a degree of government
involvement is necessary to sustain a vibrant economy, on which the
economic well-being of the population depends.

Tools of Fiscal Policy

The government has two primary fiscal tools to influence the economy.
They are revenue tools and spending tools.
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 Revenue tools
Revenue tools refer to the taxes collected by the government in various
forms. The taxes can be direct or indirect. Direct taxes are taxes levied on
the income or wealth individuals and firms. This includes income tax,
wealth tax, estate tax, corporate tax, capital gains tax, social security tax,
etc.

Indirect taxes are taxes levied on goods and services. This includes sales
tax, value added tax, excise duty, etc.

 Spending Tools
Spending tools refer to increasing or decreasing government
spending/expenditure to influence the economy.

Government spending can be in the form of transfer payments, current

spending and capital spending.

Current spending includes expenditure on essential goods and services

such as health, education, defense, etc.

Capital spending is the public investment in infrastructure such as

roads, hospitals, schools, etc.

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The above two also include subsidy or direct provision of merit goods and public goods, which
would otherwise be underprovided.

Transfer payments are the redistribution of income from taxpayers to

those requiring support, for example, unemployment benefits. It also
includes interest payments on government debt.

Fiscal policy tools have several advantages.

Spending tools enable services such as defense to benefit everyone in the

country and build infrastructure that propels growth. Spending tools
also ensure a minimum standard of living for the residents. Subsidies in
research and development also help in future economic growth.

Taxes help government in meeting their fiscal needs. By levying high

indirect taxes, the government can also discourage use of items such as
tobacco, and alcohol.

Challenges in Implementing Fiscal Policy

The government has two tools to implement its fiscal policy :

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 Taxes
 Government spending
If the economy is in recession, the government may decide to increase
aggregate demand, or decrease taxes to stimulate the economy and
increase aggregate demand. Similarly, if the economy is facing
inflationary economic boom, it may decrease spending or increase taxes.

When the government takes specific actions to influence aggregate

demand, it’s called the discretionary fiscal policy.

The discretionary fiscal policy does not always work as intended by

the government. There are many reasons as to why the fiscal policy
may not be as effective as desired, or sometimes even be
counterproductive. Some of these reasons are discussed below:

1. If the government relies on inaccurate statistics, then it’s likely to

make wrong policy decisions in the first place.

2. There could be a lag in implementing a policy decision, and/or the

impact of a policy decision. For example, by the time the
policymakers recognize the problem and take decision to do
something, it may already be too late (Recognition lag and action
lag). Once the government implements a policy, there may be a
time lag till the policy has an impact on the economy (impact lag).

3.  An expansionary fiscal policy may end up decreasing aggregate

demand because of crowding-out effect.  Increased government
borrowing leads to an increase in interest rates, which leads to a
decrease in aggregate demand.

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4. The economy may be slow because of shortage of resources rather

than lower demand. In this case, fiscal policy will not help (it may
actually increase inflation).

5. Since expansionary fiscal policy increases fiscal deficit, there is

constraint over how much deficit the government can tolerate.

6. While fiscal policy solves one problem, it may aggravate another

problem.

OBJECTIVES
The major objectives of fiscal policy are as follows:

A. Full employment

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It is very important objective of fiscal policy. Unemployment reduces the level

of production, and hence the level of economic growth. It also creates many
problems to the unemployed people in their day to day life. So, countries try to
remove unemployment and attain full employment. Full employment refers to
that situation, where there is no involuntary unemployment in the economy.
To attain this objective, government should:

 increase its spending

 lower the personal income taxes
 lower the business taxes, or
 employ a combination of increasing government spending and
decreasing taxes

However, in practice, it is difficult to achieve full employment. As the factor

markets are not perfect, factor units may lose their jobs and may not get the
new jobs immediately.

B. Price stability

Both sharp rise and sharp fall in general price level are not desirable. It is
because sharp rise in prices makes many goods and services unaffordable to
the consumers whereas sharp fall in prices discourages the producers to
produce goods and services. So, price stability is desirable. However, it should
be noted that the principle that general price level should be reasonably stable
is generally accepted, the determination of exact trends which are most
satisfactory from the stand point of welfare of society is difficult. There are
following three alternative points of view regarding the price stability (Due,
1970:513-518):

 It is sometimes argued that a slightly downward trend best serves

the interest of the community as a whole, because the gains from
increased productivity and lower cost would be shared among all
persons in society instead of going chiefly to the workers in the
industries affected. On the other hand, a downward trend would
increase the difficulty of maintaining full employment because of
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its adverse effects upon investment and business optimism.

Furthermore, such a trend appears to be impossible of attainment
in the light of present day union strength and policies.
 A gradually increasing general price level has likewise been
advocated, primarily because it would encourage investment and
lessen labour strife, since annual money wage increases would be
possible. However, this alternative would produce a gradual
worsening of the economic position of the fixed income receivers.
 The third alternative point of view, a compromise between the
other two, regards a perfectly stable general price level as the
optimum. The gains from greater productivity would go primarily
to the workers in the industries, but the injury to the economic
well-being of the fixed income groups would be avoided, as well
as dampening effects of declining prices.

C. Economic growth

It is also an important objective of fiscal policy. By means of higher rate of

economic growth the problem of unemployment can also be solved. However,
it may create some problems in the maintenance of price stability. The
developed countries, like USA, UK, Japan, etc. give attention to the relationship
of actual growth rate to the potential growth rate permitted by the
consumption – saving ratio, technological considerations and other factors.
The less developed countries give emphasis to the increase in the potential
growth rate as well as the relationship of the actual and potential growth rate
(Due, 1970:517).

The concept of actual and potential growth of output can be explained with
the help of figure (a)

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In figure (a), AB is the original production possibility curve (PPC) of the

economy. The movement from X to Y on the PPC shows the actual growth of
output. This increases the level of gross domestic product (GDP) of the
country. Such type of movement is possible by means of better utilization of
existing resources and increasing the aggregate demand by means of fiscal
policy. On the other hand, the rightward shift in PPC of the country from AB to
CD shows the potential growth of output. It is possible due to the increase in
quantity and quality of the resources, and improvement in technology. For
this, fiscal policy can be employed.

D. Resource allocation
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Resource allocation refers to assigning the available resources of the economy

to the specific uses chosen among many possible and competing alternatives.
It gives answer to what to produce and how to produce questions of the
economy (Tragakes, 2009:17). Fiscal policy should ensure the optimum
allocation of the resources. It should divert the resources from unproductive
sectors to the productive sectors of the economy. It is the long-run objective of
the government. The emphasis of the government upon the full employment,
price stability and economic growth should not overshadow the resource
allocation goal.

ALTERNATIVE FISCAL POLICIES

A. Fiscal policy during the contraction

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 increase in government spending

 reduction in personal income taxes
 reduction in business taxes
 increase in transfer payments
 practicing deficit budget

B. Fiscal policy during the expansion

 decrease in government spending
 increase in personal income taxes
 increase in business taxes
 reduction in transfer payments
 practicing surplus budget

NATURE AND TECHNIQUES

The nature of fiscal policy may be either expansionary or contractionary.

 Expansionary fiscal policy

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Expansionary fiscal policy increases the AD of the economy. It increases

the level of production, and hence the level of employment. It eliminates
the recessionary gap existing in the economy. It should be noted that
recessionary gap occurs when the equilibrium real GDP is less than the
potential real GDP of the country. In this situation, unemployment is
greater than natural rate of unemployment. It can be explained with the
help of following diagram:

In figure (b), the short-run aggregate supply (SRAS) curve and AD curve are
intersecting to each other at point E1 so that the equilibrium price level is
OP1 and equilibrium real GDP is OQ 1. Here, OQ2 is the potential GDP. It should
be noted that potential real GDP refers to the economy’s full employment level
of real GDP. As here the economy’s equilibrium real GDP is less than the
potential real GDP, there is recessionary gap. Recessionary gap is also known
as deflationary gap. Fiscal policy can be used to eliminate the recessionary
gap. For this, AD should be increased. To increase AD:

 government spending should be increased

 personal income taxes and business taxes should be reduced

Each of the above actions shift the AD curve from AD 1 to AD2 so that
economy achieves the potential real GDP as follows:
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 Contractionary fiscal policy

Contractionary fiscal policy reduces the AD of the economy. It reduces

the level of production, and hence the level of employment. It eliminates
the inflationary gap existing in the economy. It should be noted that
inflationary gap occurs when the equilibrium real GDP is greater than
potential real GDP. In this situation, unemployment is lower than the
natural rate of unemployment. It can be explained with the help of
following diagram:

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Here, equilibrium is established at point E 1 ,where there is the intersection

between the SRAS curve and AD curve so that equilibrium price level is
OP1 and equilibrium real GDP is OQ 1.As here equilibrium real GDP is greater
than potential real GDP, which is equal to OQ , there is inflationary gap.

The fiscal policy can be used to eliminate the inflationary gap. For this:

 government spending should be reduced

 personal income taxes and business taxes should be increased

Each of the above actions shift the AD curve from AD 1 to AD2 so that the
economy produces the potential real GDP as follows:

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EFFECTIVENESS
Fiscal policy becomes effective when it produces the intended result.
There are different objectives of fiscal policy, like achievement of full
employment, price stability, economic growth, and so on. If the
government is able to achieve these objectives by employing the fiscal
policy, then such fiscal policy becomes effective, otherwise it becomes
ineffective.
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Government employs the fiscal policy in order to influence the AD and

through the AD, it wants to influence other macroeconomic problems,
like inflation, unemployment, and so on. So, by means of fiscal policy,
government makes intervention in the market. It is a very important tool
in the hands of government to correct the market failure. Fiscal policy
becomes effective, when it increases the economic efficiency.
The effectiveness of fiscal policy depends upon the following factors:

 The availability and accuracy of  information

To bring the intended result, government should have sufficient
information on the related problem. It should get these
information on the appropriate time .Before employing the fiscal
policy, government requires the information about the economy.
In such situation, government can employ the appropriate fiscal
instruments to correct the problems. Similarly, during the period
of implementation of different fiscal tools, it requires information
to know whether fiscal tools are working properly or not. If the
employed fiscal tools are not working properly, government
should make changes in the use of fiscal tools. The information
collected by the government must be accurate; otherwise the use
of the fiscal policy can not solve the economic problems.
Sometimes, it may be difficult to get the information on a problem.
For example, it is difficult to get information on true value of
negative externality. Due to which it is difficult to determine a
correct rate of taxation, which reduces the actual production to
the socially efficient level.

 Size of the multiplier effect

If the size of multiplier is large, the effect of fiscal policy on AD is
also large so that fiscal policy becomes effective to achieve the
desired objectives, and vice versa.

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 Timing of the effects of fiscal policy

This significantly influences the effectiveness of fiscal policy. If the
techniques of fiscal policy take very long period of time to create
the effects on AD, fiscal policy will be less effective, and vice versa.

 Effects of change in AD
The different techniques of fiscal policy influence the AD. The
effectiveness of fiscal policy also depends upon the effects of
change in AD on the level of output, employment, inflation, and so
on. Larger such effects, stronger will be the impact of fiscal policy
and vice versa.

 Effects on incentives
The use of fiscal policy has some effects on the incentives. These
effects may be positive as well as negative. Such effects on the
incentives influence the effectiveness of fiscal policy. For example,
reduction in government spending and increase in the taxation
may have some undesirable side-effects. This influences the
effectiveness of fiscal policy. If these undesirable side-effects are
strong, fiscal policy creates inefficiencies in the economy.

 Size of accelerator effect

If the accelerator effect is strong, fiscal policy becomes more
effective.

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CONCLUSION

Government can influence the level of production, inflation and

unemployment by using the fiscal policy. Thus, fiscal policy is an
important tool in the hands of the government to achieve its
macroeconomic goals. Depending upon the existing situation of the
economy and priority of the government, it can use the different
instruments of fiscal policy as mentioned above.

Expansionary Vs. Contractionary Fiscal Policy

A government’s fiscal policy involves increasing/decreasing spending

and taxes to control the economy. The governments fiscal actions are
reflected in the fiscal budget.

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When the taxes collected are more than the spending, there’s a budget
surplus. Similarly when spending exceeds tax collection, there’s a budget
deficit.

Whether the fiscal policy is expansionary or contractionary can be

gauged by whether there is budget surplus or budget deficit. The basic
rules are given below:

 Increase in surplus indicates contractionary fiscal policy

 Decrease in surplus indicates expansionary fiscal policy
 Increase in deficit indicates expansionary fiscal policy
 Decrease in deficit indicates expansionary fiscal policy

An increase in surplus indicates that the increase in tax revenue is more

than the increase in spending, which indicates contraction.

Even though the fiscal deficit provides some indication about the
direction of fiscal policy, it may not indicate the true intention of the
government with respect to its fiscal policy. For example, if the

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government is in recession, and its taking actions to expand the

economy, the government is aiming for an expansionary policy.

However, the current economic conditions may not truly reflect that.
Therefore, to understand the true impact of the fiscal policy, the
economists adjust the budget for cyclical issues.

Fiscal Multiplier and Balanced Budget Multiplier

 Fiscal Multiplier

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As a part of its expansionary fiscal policy, when the government of a

country decides to increase spending, it has a multiplier effect on the
aggregate demand, i.e., the aggregate demand increases much more than
the actual increase in spending.

The actual increase in the aggregate demand depends on the tax rate
(again set by the government), and the marginal propensity to consume
(MCP), i.e., how much will the consumption increase with an increase in
disposable income.

Let’s take a simple example to understand this multiplier effect. Assume

that the government increases its spending by $100. Assume that the tax
rate and MCP for those who receive this money is 30% and 90%. So, a
$100 increase in government spending increases income by $100*(1-
0.30) = $70. From this disposable income of $70, people will spend $70
*0.90 = $63. This $63 will become income for other people, and their
disposable income will be $63*(1-0.30) = $44.1, out of which they will
spend $44.1*0.90 =  $39.69. This process will continue till the
additionally created disposable income becomes close to zero.

The actual increase in aggregate demand due to increased spending can

be calculated using the fiscal multiplier.

Fiscal Multiplier = 1/(1-MCP(1-t))

Where, t is the tax rate.

With t = 30% and MCP = 90%, the Fiscal multiplier will be:

Fiscal multiplier = 1/(1-0.90*(1-0.30)) = 2.7

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With a fiscal multiplier of 2.7, a $100 increase in spending will increase

the aggregate demand by $270.

As you can see, fiscal multiplier is directly related to MCP and inversely
related to the tax rate.

 Balanced Budget Multiplier

When the government increases spending, it may also want to increase

taxes to balance its budget. If the spending is increased by $100, then it
may also increase the taxes by $100 to offset the increase in spending.
However, even the taxes have a multiplier effect on the aggregate
demand. With an MCP of 90%, when the taxes are increased by $100, the
aggregate demand will initially reduce by $100*0.90 = $90. This again
will have multiple iterations, and the total decrease in aggregate demand
will be $100*0.9*2.7 = $243.

So, a $100 increase in spending and taxes each will have a net effect of
increase in aggregate demand by $27 ($270 – $243). This means that the
balanced budget multiplier is positive. The government can increase the
taxes a little more to make the net increase in aggregate demand zero

Ricardian Equivalence

The Ricardian equivalence is a proposition named after the economist

David Ricardo. The key idea behind Ricardian equivalence is that the
choice of financing the current deficit by the government (increase in tax,
or spending with debt) is irrelevant. This is because effect of this choice
on aggregate demand is the same.

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When the government has a deficit, it has two choices to raise money:
increase tax, or issue bonds. The second option of using debt is also
related to the first option, because the bonds represent debt that needs
to be repaid in the future. To repay the debt, the government is likely to
raise taxes. So, the real choice is whether to increase taxes now or in the
future.

Assume that the government issues debt to finance its extra spending,
that is, it has chosen to increase taxes later. The tax payers will now
expect that they will have to pay higher taxes in the future. To offset this
additional future cost, they will reduce their consumption and increase
saving. Therefore, the effect on the aggregate demand will be the same,
as if the government had chosen to increase taxes now.

Ricardian equivalence depends on how well the taxpayers are able to

predict their future increase in liability.

What is Fiscal Deficit?

When a government's total expenditures exceed the revenue that it
generates (excluding money from borrowings). Deficit differs from debt,
which is an accumulation of yearly deficits.

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Should We Worry About the Size of Fiscal Deficit?

At the time of this writing, the US is currently running a deficit of over $1.3
trillion. As the fiscal deficit grows, so does the government borrowings which
need to be repaid along with the interest expense. The fiscal deficit is usually
observed as a percentage of the country’s GDP. The US fiscal deficit is ~8.5%
of the GDP, which seems pretty high compared to ~3.2% in 2008. For some
people this is a big cause of concern, while for others the concern is overrated.

Why High Fiscal Deficit is a real concern?

1. It leads to an increase in future taxes.

2. If investors don’t refinance, government may default, or print more

money.

3. Printing money will cause high inflation.

4. Crowding-out effect. Increased government borrowing leads to an

increase in interest rates, which leads to a decrease in aggregate
demand. The purpose of spending more has failed

Why High Fiscal Deficit is not that big a problem?

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1. If the debt raised is used for capital investment, it will pay off in the
future.

2. The government may want to consider tax reforms.

3. If Ricardian equivalence holds true, this is not a problem as there won’t

be any impact on aggregate demand.

4. Deficits can help in increasing GDP and employment.

5. If most debt is raised domestically, the problem is not that big.

What Are the Four Most Important Limitations of

Fiscal Policy?

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Lag Time
 Lag time is the time it takes to implement fiscal policy. For example,
governments around the world announced several fiscal and monetary
policy initiatives to deal with the 2008 financial crisis. Central banks,
including the U.S. Federal Reserve, implemented the monetary policies
very quickly, including cutting interest rates and increasing the money
supply. Monetary policy changes affect the economy faster because
financial institutions generally match Federal Reserve rate cuts
immediately. However, fiscal policy measures, such as income tax cuts
and stimulus spending, usually require changes to existing legislation or
the creation of new legislation. Economic circumstances might be quite
different by the time legislation goes through the committee process
and enacted into law.

Limited Discretion
 Fiscal policy makers often have limited discretion because a
significant portion of the budget is reserved for non-discretionary
spending, such as Social Security and Medicare. This limitation
becomes more severe when governments run large budgetary
deficits and the resulting debt servicing costs limit policy-making
flexibility. Deficit spending also worsens the long-time fiscal
position because rising interest rates increase debt servicing costs
and put pressure on lawmakers to reduce rather than increase
spending. Electoral realities may also limit budgetary discretion
because short-term spending measures to improve electoral
prospects takes precedence over prudent long-term fiscal
planning

Information Availability

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 Real gross domestic product might be below, above or at full

Gross Domestic Product, or GDP, which is the maximum amount
of individual consumption, government investment, private sector
investment and net exports in the economy. Therefore, policy
makers might not be able to determine whether contractionary or
expansionary policy is necessary. Contractionary policy includes
spending cuts and increased taxes, while expansionary policy
refers to tax reductions and stimulus spending. Policy makers also
require accurate forecasts of the impact of various fiscal policy
alternatives. However, economic forecasting is not an exact
science, which makes long-range budgetary projections
inherently unreliable.

Crowding-Out Effect
 Fiscal policy could have a crowding-out effect. This occurs when
government borrowing hampers private sector borrowing.
Investors are more likely to buy low-risk government bonds than
riskier corporate bonds. This makes it more difficult -- and
potentially more expensive in the form of higher interest rates --
for the private sector to raise funds for business expansion and
job creation.

Terms relating to fiscal policy

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 Fiscal Stance - This refers to whether the government is

increasing AD or decreasing AD, e.g. expansionary or tight
fiscal policy
 Fine Tuning - This involves maintaining a steady rate of
economic growth through using fiscal policy. However this
has proved quite difficult to achieve precisely.
 Automatic fiscal stabilisers -If the economy is growing,
people will automatically pay more taxes ( VAT and Income
tax) and the Government will spend less on unemployment
benefits. The increased T and lower G will act as a check on
AD. But, in a recession the opposite will occur with tax
revenue falling but increased government spending on
benefits, this will help increase AD
 Discretionary fiscal stabilisers - This is a deliberate
attempt by the govt to affect AD and stabilise the economy,
e.g. in a boom the government will increase taxes to reduce
inflation.
 The multiplier effect - When an increase in injections causes
a bigger final increase in Real GDP.
 Injections (J) - This is an increase of expenditure into the
circular flow, it includes govt spending(G), Exports (X) and
Investment (I)
 Withdrawals (W) - This is leakages from the circular flow
This is household income that is not spent on the circular
flow. It includes: Net savings (S) + Net Taxes (T) + Net
Imports (M)

Criticism of Fiscal Policy

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1. The government may have poor information about the state of the
economy and struggle to have the best information about what the
economy needs.

2. Time lags. To increase government spending will take time. It could

take several months for a government decision to filter through
into the economy and actually affect AD. By then it may be too late.

3. Crowding out. Some economists argue that expansionary fiscal

policy (higher government spending) will not increase AD, because
the higher government spending will crowd out the private sector.
This is because government have to borrow from the private sector
who will then have lower funds for private investment.

4. Government spending is inefficient. Free market economists argue

that higher government spending will tend to be wasted on
inefficient spending projects. Also, it can then be difficult to reduce
spending in the future because interest groups put political
pressure on maintaining stimulus spending as permanent.

5. Higher borrowing costs. Under certain conditions, expansionary

fiscal policy can lead to higher bond yields, increasing the cost of
debt repayments.

Evaluation of Fiscal Policy

The success of fiscal policy will depend on several factors, such as:

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1. It depends on the size of the multiplier. If the multiplier effect is large,

then changes in government spending will have a bigger effect on
overall demand.

2. It depends on the state of the economy. Fiscal policy is most effective in

a deep recession where monetary policy is insufficient to boost demand.
In a deep recession (liquidity trap). Higher government spending will
not cause crowding out because the private sector saving has increased
substantially.

Liquidity trap and fiscal policy – why fiscal policy is more important
during a liquidity trap.

3. It depends on other factors in the economy. For example, if the

government pursue expansionary fiscal policy, but interest rates rise
and the global economy is in a recession, it may be insufficient to boost
demand.

4. Bond yields. If there is concern over the state of government finances,

the government may not be able to borrow to finance fiscal policy.
Countries in the Eurozone experienced this problem in the 2008-13
recession.

Objective of Monetary Policy

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The primary objective of BSP's monetary policy is to promote a low and stable
inflation conducive to a balanced and sustainable economic growth. The
adoption of inflation targeting framework for monetary policy in January
2002 is aimed at achieving this objective.

What is Monetary Policy?

measures or actions taken by the central bank to influence the general price
level and the level of liquidity in the economy. Monetary policy actions of the
BSP are aimed at influencing the timing, cost and availability of money and
credit, as well as other financial factors, for the main objective of stabilizing
the price level.

 Expansionary Monetary Policy

monetary policy setting that intends to increase the level of

liquidity/money supply in the economy and which could also result in a
relatively higher inflation path for the economy. Examples are the
lowering of policy interest rates and the reduction in reserve
requirements. Expansionary monetary policy tends to encourage
economic activity as more funds are made available for lending by
banks. This, in turn, increases aggregate demand which could eventually
fuel inflation pressures in the domestic economy.

 Contractionary Monetary Policy

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monetary policy setting that intends to decrease the level of

liquidity/money supply in the economy and which could also result in a
relatively lower inflation path for the economy. Examples of this are
increases in policy interest rates and reserve requirements.
Contractionary monetary policy tends to limit economic activity as less
funds are made available for lending by banks. This, in turn, lowers
aggregate demand which could eventually temper inflation pressures in
the domestic economy.

Which is More Effective Monetary or Fiscal Policy?

In recent decades, monetary policy has become more popular because:

 Monetary policy is set by the Central Bank, and therefore reduces

political influence (e.g. politicians may cut interest rates in desire to
have a booming economy before a general election)
 Fiscal Policy can have more supply side effects on the wider economy.
E.g. to reduce inflation – higher tax and lower spending would not be
popular and the government may be reluctant to purse this. Also lower
spending could lead to reduced public services and the higher income
tax could create disincentives to work.
 Monetarists argue expansionary fiscal policy (larger budget deficit) is
likely to cause crowding out – higher government spending reduces
private sector spending, and higher government borrowing pushes up
interest rates. (However, this analysis is disputed)
 Expansionary fiscal policy (e.g. more government spending) may lead to
special interest groups pushing for spending which isn’t really helpful
and then proves difficult to reduce when recession is over.
 Monetary policy is quicker to implement. Interest rates can be set every
month. A decision to increase government spending may take time to
decide where to spend the money.

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However, the recent recession shows that Monetary Policy too can have many
limitations.

 Targeting inflation is too narrow. This meant Central banks

ignored an unsustainable boom in housing market and bank
lending.
 Liquidity Trap. In a recession, cutting interest rates may prove
insufficient to boost demand because banks don’t want to lend
and consumers are too nervous to spend. Interest rates were cut
from 5% to 0.5% in March 2009, but this didn’t solve recession in
UK.
 Even quantitative easing – creating money may be ineffective if
banks just want to keep the extra money in their balance sheets.
 Government spending directly creates demand in the economy
and can provide a kick-start to get the economy out of recession.
Thus in a deep recession, relying on monetary policy alone, may
be insufficient to restore equilibrium in the economy.
 In a liquidity trap, expansionary fiscal policy will not cause
crowding out because the government is making use of surplus
saving to inject demand into the economy.
 In a deep recession, expansionary fiscal policy may be important
for confidence – if monetary policy has proved to be a failure.

Impact on the Composition of Output

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Monetary policy is seen as something of a blunt policy instrument – affecting

all sectors of the economy although in different ways and with a variable
impact

Fiscal policy changes can be targeted to affect certain groups (e.g. increases in
means-tested benefits for low income households, reductions in the rate of
corporation tax for small-medium sized enterprises, investment allowances
for businesses in certain regions)

Consider too the effects of using either monetary or fiscal policy to achieve a
given increase in national income because actual GDP lies below potential GDP
(i.e. there is a negative output gap)

 Monetary policy expansion

Lower interest rates will lead to an increase in both consumer and fixed
capital spending both of which increases current equilibrium national
income. Since investment spending results in a larger capital stock, then
incomes in the future will also be higher through the impact on LRAS.

 Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending)
adds directly to AD but if financed by higher government borrowing,
this may result in higher interest rates and lower investment. The net
result (by adjusting the increase in G) is the same increase in current
income. However, since investment spending is lower, the capital stock
is lower than it would have been, so that future incomes are lower.

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Differences in the Effectiveness of Monetary and Fiscal

Policies

When the economy is in a recession (when business and consumer confidence

is very low and perhaps where deflationary pressures are taking hold)
monetary policy may be ineffective in increasing current national spending
and income. The problems experienced by the Japanese in trying to stimulate
their economy through a zero-interest rate policy might be mentioned here. In
this case, fiscal policy might be more effective in stimulating demand. Other
economists disagree – they argue that short term changes in monetary policy
do impact quite quickly and strongly on consumer and business behaviour.
Consider the way in which domestic demand in both the United States and the
UK has responded to the interest rate cuts introduced in the wake of the
terror attacks on the USA in the autumn of 2001

However, there may be factors which make fiscal policy ineffective aside from
the usual crowding out phenomena. Future-oriented consumption theories
hold that individuals undo government fiscal policy through changes in their
own behaviour – for example, if government spending and borrowing rises,
people may expect an increase in the tax burden in future years, and therefore
increase their current savings in anticipation of this

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Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect
the time lags are variable

Monetary policy in the UK is extremely flexible (rates can be changed each

month) and emergency rate changes can be made in between meetings of the
MPC, whereas changes in taxation take longer to organize and implement.

Because capital investment requires planning for the future, it may take some
time before decreases in interest rates are translated into increased
investment spending. Typically it takes six months – twelve months or more
before the effects of changes in UK monetary policy are felt.

The impact of increased government spending is felt as soon as the spending

takes place and cuts in direct and indirect taxation feed through into the
economy pretty quickly. However, considerable time may pass between the
decision to adopt a government spending programme and its implementation.
In recent years, the government has undershot on its planned spending, partly
because of problems in attracting sufficient extra staff into key public services
such as transport, education and health

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What are the similarities between fiscal and monetary

policy?

They're both methods (of macroeconomics) used by the government to

stabilize the economy. 

 Fiscal policy 

mainly involves changing expenditures or changing taxes to

increase aggregate demand and achieve economic growth and
higher employment. 

 Monetary policies

involve changing the money supply in order to affect interest rates

in order to increase employment and achieve stable prices. They
are basically two methods through which you can achieve the same
goal.

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Fiscal Program
For 2013, we aim to increase our target revenues to 1.78 billion, which would
translate to 14.9 percent of the proposed GDP for the same year, with a
projected growth rate of 14.1, including the impact of the pending sin tax law,
when it is passed.

Disbursements projections are also positive for 2013, with a target of P2.021
trillion, a record in terms of public budgeting. The deficit target is also set
lower than the target set for 2012, at P241 billion, or 2 percent of the
projected GDP.

Revenues

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Disbursements

Deficit

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