Lecture 10

Fiscal policy

Reading:
Sloman and Garratt,
Chapter 13
Prepared by:
Dr. Bawani Lelchumanan
ECN1014 (DEF, SBS)

INTRODUCTORY
ECONOMICS
GOVERNMEN
T FINANCES Reading:
AND SOME Sloman and Garratt,
Chapter 13
TERMINOLOG
Y
THE ROLES OF
FISCAL POLICY
Fiscal policy refers to the use of government
expenditure (G) and taxes (T) to influence the level of
aggregate demand.
There are two possible roles as far as controlling
aggregate demand is concerned:
 Removing inflationary or recessionary problems or
gaps
 Smoothing out the business cycle by preventing
excessive inflationary or recessionary pressure
GOVERNMENT, FISCAL POLICY
AND BUDGET BALANCE
Since fiscal policy involves adjusting the level of
government expenditure and taxes, this has the effect of
influencing the budget balance.
 A budget surplus is where the central government’s
tax revenues exceed its expenditure. (T>G)
 A budget deficit is where the central government’s
expenditure exceeds its tax revenues. (G>T)
Debt is incurred if the government runs a budget
deficit.
 National debt will accumulate if the government
persistently runs deficit over several years.
If the public sector spends more than it receives, it will
have to finance this deficit through borrowing known
as public sector net borrowing (PSNB).
If the public sector runs a surplus (i.e. negative PSNB),
it would be used to repay the accumulated debts from
the past.
 FISCAL
POLICY AND Reading:
Sloman and Garratt,
AUTOMATIC Chapter 13

STABILISERS
WHAT AUTOMATIC
STABILISERS ARE
Even without deliberate government actions, the size of
public sector surplus or deficit will automatically change
according to the level of national income.
In theory, business cycles will be dampened by such “in-
built” and automatic stabilisers.
Automatic stabilisers include:
 Taxes which automatically rise (or fall) when national
income rises (or fall)
 Government expenditures which automatically fall (or
rise) when national income rises (or fall)
 HOW AUTOMATIC
STABILISERS WORK
As national income falls during the recession,
 More people would be pushed to lower tax brackets,
thus reducing tax revenues received by the
government.
 More people would be unemployed, thus making the
government to provide more unemployment benefits.
As national income rises during the boom,
 More people would be pushed to higher tax brackets,
thus raising tax revenues received by the government.
 Less people would be unemployed, thus making the
government to provide less unemployment benefits.
DISCRETIONA
RY FISCAL
POLICY AND Reading:
MACROECON Sloman and Garratt,
Chapter 13
OMIC
STABILISATIO
N
DEFINING
DISCRETIONARY FISCAL
POLICY
Discretionary fiscal policy is a deliberate fiscal action
initiated by the government to influence aggregate
demand by changing tax rates or government
expenditures.
Examples of discretionary fiscal policy:
 The Goods and Services Tax in Singapore will be raised
from 7% to 9%.
 The corporate tax in Malaysia will be reduced from 25%
to 24%.
HOW DISCRETIONARY
FISCAL POLICY WORKS
Contractionary fiscal policy responds to excessive
aggregate demand in an overheating economy by:
 Reducing government expenditures (G)
 Raising taxes (T)

Expansionary fiscal policy responds to deficient aggregate

demand during a recession by:
 Raising government expenditures (G)
 Reducing taxes (T)
CHANGING GOVERNMENT
EXPENDITURES (G)
Suppose that the economy is in a recession and
that current macroeconomic equilibrium falls short
of full employment.
An increase in government spending directly
raises aggregate demand, thereby shifting the AD
curve rightward, moving the macroeconomic
equilibrium closer to the full employment level.
 CHANGING
TAXES (T)
Again, suppose that the economy is in a recession.
Alternatively, the government may move the macroeconomic
equilibrium closer to the full employment level by reducing
taxes.
A tax cut increases the disposable income of the private
sector, which in turn raises consumption and investment
spending, thereby shifting aggregate demand curve
rightward.

T ® C or I ® AD ® P ® Y
Reducing taxes may have a smaller impact on aggregate
demand than increasing government expenditures because
households or firms may:
 Save some of this additional disposable income and
spend (or invest) the rest of it.
 Perceive tax cuts to be only temporary and expect tax
rates to rise again in the future, thus reluctant to spend
or invest.
DISCRETIONA
RY FISCAL
POLICY: Reading:
PROBLEMS Sloman and Garratt,
Chapter 13
AND
COMPLICATIO
NS
The effectiveness of discretionary fiscal policy in
achieving the intended macroeconomic outcomes may
be hampered by various practical problems:

 Crowding-out
 Expectations of changes in future taxes
 Market uncertainties and confidence
 Random shocks
 Problem in timing
 Political considerations
CROWDIN
G-OUT
 If the government relies on pure fiscal policy (i.e.
borrowing from non-bank private sector) to finance
its spending, money supply would remain
constant.
 By doing so, the government may be competing
together with the private sector for finance, driving
up overall interest rates.
 As interest rates increase, the cost of borrowing
increases as well, discouraging (or “crowding
out”) investment and consumption on credit.
EXPECTATIONS OF
CHANGES IN FUTURE
TAXES
Current tax cuts may fail to achieve their intended
objectives if households and firms expect taxes would
be raised again in the future.
If people expect tax cuts to be temporary, they are
more likely to save their disposable income, thus
making tax cuts less effective in stimulating
aggregate demand.
MARKET UNCERTAINTIES
AND CONFIDENCE
An expansionary fiscal policy may function like a “pump
primer” (i.e. fiscal pump-priming) just to kick start
economic recovery.
 Continuation of the recovery is left to the market (i.e.
private sector will pick up investment and consumption if
they believe that fiscal pump-priming would work).
Fiscal pump-priming may fail to restore market
confidence if the market is extremely pessimistic and
believes that:
 Recovery is short-lived
 Recession is unusually severe and may last longer
RANDOM
SHOCKS
Formulation of fiscal action can never fully capture
unpredictable events.

 Terrorism
 War and military campaign
 Financial shocks or meltdown
 Abrupt changes in political landscape
PROBLEMS
OF TIMING
Recognition lag
 Business cycles can be irregular and hardly discernible.
 Forecasting can be extremely unreliable.
 Governments may be reluctant to take actions unless they are
convinced by the seriousness of the economic problems.
Administrative lag
 Changes in spending and taxes cannot be effected overnight as they
are subjected to parliamentary and legislative scrutiny.
Operational lag
 It takes times for fiscal action to leave its intended impact upon
output, employment and the price level.
POLITICAL
CONSIDERATIONS
Discretionary fiscal policy is particularly vulnerable
to political business cycles.
Fiscal policy which is economically inappropriate
may be pursued by politicians for the sake of
achieving short-term political objectives (i.e.
getting reelected).
 FISCAL
POLICY IN
TOUGH
TIMES: Reading:
Sloman and Garratt,
RULES, Chapter 13

DISCRETION
AND
AUSTERITY
TWO DIFFERENT CAMPS:
RULES OR DISCRETION?
It is debated whether the government or
policymakers should be:
 Limited by a set of rules in the conduct of fiscal
policy, or
 Given the discretion to actively adjust fiscal
policy to fine-tune and influence the business cycle
THE CASE
FOR RULES
Discretionary fiscal policy can be easily hijacked by
politicians for political purposes.
 Fiscal policy may lead to economic fluctuations that
reflect the electoral calendar.
 Fiscal actions may be politically popular but
economically wasteful and imprudent.
Economic history confirms that most politicians often
have uncontrolled appetite for excessive spending,
building up public debt and deficit.
If politicians cannot be trusted to run fiscal policy
responsibly, they should be limited by fiscal rules and
targets which control how they tax and spend.
Examples of fiscal rules and targets:
 UK: Golden Rule
 Public sector debt-GDP ratio to be kept under 40%
 Borrowing only for financing capital expenditures
Supporters of fiscal rules argue that limiting the
government’s ability to tax and spend is necessary
because uncontrolled public debt and deficit may hamper
long-term economic growth:

 Public sector consumes substantial resources, thus

limiting the growth of the private sector.
 Higher deficit-spending and debt at present implies
higher taxes and burden for future generations.
 National insolvency and bankruptcy may become
inevitable.