COURSE PLAN

Module 1 Basics of Macroeconomics

Module 2 National Income Determination

Module 3 Economic Fluctuations and Unemployment

Midterm Examination ​(tentative dates: November 17-18, 2020)

Module 4 Inflation and Economic Policies

Module 5 Stock Market 101

Module 6 International Economics

Final Examination ​(tentative dates: December 22-23, 2020)

 Module 4

Inflation and Economic Policies

Lesson 2: Fiscal Policy

Fiscal policy ​is the use of government spending and taxes to influence the nation’s
spending, employment and price level. It is also defined as the manipulation of the
national government budget to attain price stability, relatively full employment, and a
satisfactory rate of economic growth. In other words, in order for a government to attain
these goals, it must manipulate public spending and taxes. Fiscal policy is, therefore, an
instrument of demand management which seeks to influence the level of economic
activity in an economy through the control of taxation and government spending.

Budgets Deficits and Surpluses

When government revenues from taxes are equal to government expenditures which
include both purchases of goods and services and transfer payments like pensions to
retirees and the conditional cash transfer, the government has achieved a ​balanced
budget.

Nevertheless, the budget need not be balanced. Thus, a ​budget deficit ​is present when
total government spending exceeds total government revenue from all sources. When a
budget deficit is present, the government must borrow funds to finance the excess of its
spending relative to revenue. It borrows domestically by issuing interest-bearing bonds
such as treasury bills that become part of what we call national debt, the total amount of
outstanding government bonds. If domestic bonds are lacking, then it borrows from
foreign creditors such as the World Bank, Asian Development Bank, and other foreign
aid agencies. Conversely, a ​budget surplus ​is present when the government’s revenues
exceed its total expenditures. The surplus allows the government to reduce its
outstanding debt.
Keynesian View of Fiscal Policy

Prior to the 1960s, the desirability of a balanced budget was widely accepted among
business and political leaders. Keynesian economists, however, were highly critical of
this view. Keynesians argued that the government budget should be used to promote a
level of aggregate demand consistent with the full employment rate of output.

How might policymakers use the budget to stimulate aggregate demand? First, an
increase in government purchases of goods and services will directly increase
aggregate demand. As the government spends more on highways, flood control
projects, education, irrigation facilities, national defense, and police protection, demand
in goods and services will increase. Second, changes in tax policy will also influence
aggregate demand. For example, a reduction in personal taxes will increase the current
disposable income of households. As their after-tax income rises, individuals will spend
more on consumption. In turn, this increase in consumption will stimulate aggregate
demand. Similarly, a reduction in business taxes increases after-tax profitability, which
will stimulate both business investment and aggregate demand.

When an economy is operating below its potential capacity, the Keynesian model
suggests that the government should institute ​expansionary fiscal policy​. Under this
policy, the government can undertake any of the following ways: increase government
spending, or decrease taxes; or increase government spending and decrease taxes. In
other words, the government should either increase its purchases of goods and services
or cut taxes or both. Of course, this policy will increase the government's budget deficit.
In order to finance the enlarged budget deficit, the government will have to borrow from
either private domestic sources or foreign sources. Conversely, the government can do
contractionary fiscal policy when the economy is overheating because of full
employment. With regard to ​contractionary fiscal policy,​ the government can do
either of the following: decrease government spending; increase taxes; or decrease
government spending and increase taxes.

Let us now describe how fiscal policy works. Generally, the fiscal authorities in the case
of the Philippines, the Department of Finance can employ a number of taxation
measures to control aggregate demand or public spending. Direct taxes on individuals
and on companies can be increased or decreased if household spending needs to be
reduced or increased so as to reduce inflation or increase aggregate demand to reduce
unemployment. Why is this so? This is because an increase in income tax reduces
households' disposable income, and similarly an increase in corporate income tax
leaves companies with less profit available to pay dividends and reinvestment, or vice
versa. Alternatively, household spending can be reduced by increasing indirect taxes
like Value Added Tax (VAT), or an increase in excise duties on particular products such
as oil, distilled products, wines, and cigarettes, to increase prices, leading to a reduction
in the purchasing power of money. Lower or higher disposable income due to high or
low tax rates lowers or increases the capacity of households to spend, thus, limiting the
inflationary pressure or expanding aggregate demand so as to counteract
unemployment.

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Take note that taxation and government spending are linked together in terms of the
government's overall fiscal or budget position. Thus, total spending in the economy is
reduced by the twin effects of increased taxation and expenditure cuts with the
government running a budget surplus. If the objective is to increase spending during
recession, then the government operates a budget deficit by reducing taxation and
increasing its expenditure.

On the other hand, a decrease in government spending and an increase in taxes reduce
aggregate demand and through the multiplier process serves to reduce inflationary
pressures when the economy is “overheating." In contrast, an increase in government
spending and/or decrease in taxes stimulate aggregate demand and via the multiplier
effect creates additional jobs to counteract unemployment during recessionary periods.

The use of budget deficits was First advocated by John Maynard Keynes as a means of
counteracting the mass unemployment of the 1920s and 1930s brought about by the
Great Depression in the United States. With the widespread acceptance of Keynesian
ideas by Western governments in the period since 1945, fiscal policy was used as a
means of “fine-tuning” the economy to achieve full employment.

In practice, however, the application of fiscal policy as a short-term stabilization

technique encounters a number of problems which reduce its effectiveness. Taxation
rate changes, particularly alterations to income tax rates as well as indirect tax rates,
are administratively cumbersome to initiate and take time to implement as it requires
congressional approval. Thus, the economy may have already rebounded but congress
may still be deliberating on the tax rate changes. Likewise, a substantial proportion of
government expenditure on, for example, schools, roads, hospitals, public
infrastructures and defense reflects longer-term economic and soch commitments and
cannot easily be reversed without lengthy political lobbying. Also, changes in taxes or
expenditure produce “multiplier" effects, but to an indeterminate extent.