Fiscal Policy and the

Federal Budget
Ch. 10, Macroeconomics, Roger A Arnold
 The Government
Remember the domestic economy can be
divided into three sectors:
1. Households 2. Business Firms 3. Government
In this chapter we study the role of the Government.
Like households and business firms, the government
also earns and spends. The spending of government
is called government expenditures. Government
expenditures are the sum of government purchases
and government transfer payments.
Government expenditures = government purchases + transfer payments
 Government Expenditures
Government purchases are goods and services bought
by the government (E.g., cements, rods, steel for
building roads and highways).
Government purchases are payments that are not
made in return for goods and services (E.g., subsidies
/ cash given to farmers. The government does not
receive anything in return from the farmers).
In 2019, Bangladesh government spent around
3,813,723 million taka, which was around 15% of the
GDP of 2019. That’s a lot of money!
 Government Tax Revenues
How does the government earn the money it spends?
The main source of income of the government is tax
revenues, which the government earns by taxing
households and business firms. There are mainly
three types of tax systems:
1. Progressive income tax: System in which one’s tax
rate rises as taxable income rises
2. Proportional income tax: System in which tax rate is
the same regardless of taxable income
3. Regressive income tax: System in which a person’s tax
rate declines as his her taxable income rises
 Continued
Bangladesh Government implements the
following progressive tax system.
 The Government Budget
Government Budget: A plan for the federal government’s tax
revenues and expenditures for the coming year.

The budget can be in one of the three states

1) Budget Deficit: Gov expenditures > Tax revenues

2) Budget Surplus: Tax revenues > Gov expenditures
3) Balanced Budget: Gov expense = Tax revenues
How can the government spend more than it earns
(budget deficit)? By borrowing from creditors (local
and foreign banks). Bangladesh borrowed mostly
through national savings certificates (shonchoy
potro) in 2020.

Public Debt: Total amount that the government owes to

its creditors (local and foreign banks).

In 2019, the national debt of Bangladesh amounted to

around 107.63 billion U.S. dollars.
 Fiscal Policy
Economic goals: Low unemployment, Price Stability and
economic growth
The government may help an economy achieve these
goals through fiscal policy
Fiscal Policy: Changes in government expenditures
and/or taxes. Two types of fiscal policy:
1. Expansionary Fiscal Policy: Increase in government
expenditures and/or decrease in taxes
2. Contractionary Fiscal Policy: Decrease in government
expenditures and/or increase in taxes
 Continued
If the change in fiscal policy is deliberate then it is said
to be discretionary fiscal policy. If government
expenditures and taxes change due to economic
events, then it is referred to as automatic fiscal policy.

Two important points:

• Here we focus on discretionary fiscal policy
• Any change in government expenditures is due to
change in government purchases. We assume
transfer payments are constant.
 11-3 Demand Side Fiscal Policy
• Exhibit 2. Important.
Remember, AD curve shifts if C, I, G or NX changes.
In case of expansionary fiscal policy, G increases and
taxes decreases (which causes C and/or I to increase).
Therefore, AD shifts right. Can be used when the
economy is in a recessionary gap.
Contractionary fiscal policy shifts the AD curve left due
to the opposite reasons…G decreases and C and/or I
decreases since taxes are increased. Can be used when
the economy is in an inflationary gap.
 11-3c Crowding Out
• Crowding Out: The decrease in private expenditures
that occurs as a consequence of increase in government
spending or the financing needs of a budget deficit
• Direct effect: The government spends more on public
libraries and individuals buy fewer books at book-stores
• Indirect effect: The government spends more without
raising taxes…borrows more which increases the
demand for credit in the credit market causing the
interest rate to rise. As a result investment falls.
Types of crowding out:
1) Complete crowding out: A decrease in one or more
components of private spending that completely
offsets the increase in government spending.
2) Incomplete crowding out: A decrease in one or more
components of private spending that partially
offsets the decrease the government spending.
3) Zero crowding out: Private spending does not
change due to change in government spending
In case of complete crowding out or incomplete
crowding out, expansionary fiscal policy will have less
impact on AD and Real GDP than theory predicts.
Exhibit 3. Important.
 11-3d Lags and Fiscal Policy
1. The Data Lag. Policy makers are not aware of changes in the
economy as soon as they happen
2. The wait-and-see Lag. Cautious wait and see attitude
3. The legislative lag. Lag due to political and bureaucratic process
4. The transmission lag: The enactment and implementation
5. The Effectiveness Lag: The lag between implementation and
effect
By this time the economic problem 1) may no longer exist
2) May not exist to the degree it once did 3) may have changed
altogether.

PS. This along with the crowding out are reasons why fiscal policy
might not be effective
 11-4 Supply Side Fiscal Policy
Marginal Tax Rates and Aggregate Supply
Marginal Tax Rate: The change in a person’s tax
payment divided by the change in taxable
income:

Lower marginal tax rates might increase the

incentive to work…aggregate supply increases
 11-4 Laffer Curve: Tax Rates and Tax
Revenues
Laffer Curve explains the possible relationship between tax rates and tax
revenues. Exhibit 7.

Tax revenues = tax base x average tax rate

Tax base: The total amount of taxable income

Upward sloping portion of the curve in Exhibit 7 indicates direct relationship

between tax revenues and tax rates (when percentage decline in tax base is
less than the income). Note: We assume tax base falls if tax rate increases.
Since people lose incentive to work so total taxable income decreases.
The downward sloping portion of the Laffer curve indicates an inverse
relationship between tax rate and tax revenue…occurs when the decline in tax
base is greater than the percentage increase in average tax rate.