Macroeconomics Revision – Fiscal Policy
I. Definitions
1. Fiscal Policy
a. Fiscal policy is the use of taxation and government spending to manage aggregate demand in order to
achieve the government's macroeconomic aims.
b. The government usually adopts expansionary fiscal policy to encourage economic growth/reduce cyclical
unemployment/reduce deflation/ by tools increasing aggregate demand, such as decrease in income tax or
increase in government spending.
c. The government usually adopts contractionary fiscal policy to control inflation/reduce current account
deficit by tools decreasing aggregate demand, such as increase in income tax or decrease in government
spending.
2. Budget
a. The government's annual budget is a statement of its fiscal policy.
b. A budget surplus arises when tax revenue exceeds government spending. A budget deficit occurs when
government spending exceeds tax revenue. A balanced budget is when government spending
matches tax revenue.
c. When an economy is running budget surplus, its tax revenue exceeds government spending, and this
would keep decreasing aggregate demand as this could be regarded as higher withdrawal (tax revenue) than
injection (government spending). Therefore, running a budget surplus could be regarded as a contractionary
fiscal policy
d. When an economy is running budget deficit, its government spending exceeds government revenue, and
this would keep increasing aggregate demand as this could be regarded as higher injection (government
spending) than withdrawal (tax revenue). Therefore, running a budget surplus could be regarded as an
expansionary fiscal policy
3. National Debt
a. National debt is total government debt built up overtime.The national debt is often expressed as a
percentage of GDP
b. If a government has a budget deficit in one year it will add to the country’s national debt.
c. In contrast, the extra reveune earned from a budget surplus can be used to pay off part of the national debt.
II. Effectiveness
1. Automatic Stabiliser
Government might also not use discretionary fiscal policy, which is deliberate changes in government
spending and taxation, to fight against the business cycle and negative output gap, but to wait for automatic
stabiliser to make effects. Automatic stabilisers offset fluctuations in economic activity by increasing
aggregate demand during the period of economic downturn and decreasing aggregate demand during the
period of economic upturn automatically. During the economic upturn, national income is high and
increasing, which leads to more tax revenue from both income tax and indirect tax as there would be high
consumption as well. There would be low government spending because with low unemployment rate,
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government does not need to pay a lot for unemployment benefits and other welfare. As a result, the
automatic decrease in government spending and increase in tax revenue decreases aggregate demand.
Alternatively during the economic downturn, tax revenue falls and payment for welfare increases
automatically because there would be job losses and fall in consumption. Therefore, aggregate demand
increases automatically to mitigate the effects of fluctuations anti-cyclically.
However,the problem with automatic stabiliser is that it might not be quite influential if the marginal rate of
tax and amount of welfare payment is not large enough to provide offsets on aggregate demand. For
example, if a government adopts an income tax that only charges a universal 10% of the total income, then
probably the change in the tax revenue collected by the income tax would have minor effect on the
adjustment of aggregate demand.
2. Unexpected Responses from Consumers and Business – Confidence
a. Consumer Confidence
The impact of changes in income tax might be compromised if consumer confidence is very optimistic.
Consumer confidence is the feelings of consumers on the current and future state of economy. It is mainly
affected by the previous macroeconomic performance and the expectation of consumers on their future
income. When the economy is in economic boom or overheated economy with people believing that their
incomes would keep increasing as they previously do, consumers might feel too optimisitc about their
future. In this case, an increase in income tax might not be sufficient to persuade consumers into consuming
less. As a result, the impact of changes in income tax would be limited
b. Business Confidence
The impact of changes in corporation tax might be compromised if business confidence is very pessimistic.
Business confidence is the feelings of entrepreneurs and managers on the current and future state of
economy. It is mainly affected by the previous macroeconomic performance and the expectation of
businesses on the future demand for their products. When the economy is in recession with businesses losing
their orders and profits, businesses might feel pessimistic about their future. In order to prepare for potential
risks in the future, businesses might become reluctant to reinvest to expand their production. In this case, a
cut in corporation tax / a cut in interest rate might not be sufficient to persuade businesses into investing
more. As a result, the impact of changes in corporation tax would be limited.
3. Time Lags
The time lag of the effects of fiscal policy should also be noticed. There is a risk that the policy may act to
reinforce the business cycle rather than counter it. For example, when the economy starts to decline, it
usually takes government some time to realise that it is necessary to react and adopt expansionary fiscal
policy, to decide what policy it should adopt and to finally implement them. And even with such deliberate
changes in income tax, corporation tax or government spending, which sends a positive signal to the market
regarding the resolution of government to boost the economy, it usually takes longer than expected for
consumers and businesses to restore their confidence and react to the changes. As a result, when the changes
finally take place and start to make effects, the economy has already stepped out of the recession and started
a new round of upturn or a new period of economic boom. In this case, expansionary fiscal policy will have
an impact when the negative output gap has been closed and a positive output gap is occurring, which means
that the time lag of fiscal policy finally lead to unintended consequences of unnecessary inflationary
pressure or even more serious problem.
4. Whether the economy is at full capacity
The impacts of decrease in income tax depend on whether the economy is
running on its full capacity. This can be shown with the Keynesian LRAS
model. When aggregate demand increases from AD1 to AD2, since the real
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output is capped by productive capacity, there would be no increase in real output. Real output would still be
the full employment level of output Yfe.This would not reduce unemployment because there are no cyclical
unemployment. It would only result in higher price level, indicating higher inflation rate. On the other hand,
if the economy is running with large spare capacity and aggregate demand increases, there would be
increase in real output without significant inflation. Since more factors of production would be needed to
deliver higher real output,there would be a reduction in cyclical unemployment.
5. Crowding out (New Classical) / Crowding in (Keysian)
There are different views from different groups of economists. New classical economists argue that public
sector spending would crowd out private sector spending. If the increase in government spending is funded
by public sector borrowing, this would reduce the funds available for private sector to borrow. This would
also increases demand for loanable funds and then raise the rate of interest, which discourages private sector
borrowing for consumption and investment.
Alternatively, Keynesians reject the idea of crowding out and suggest that crowding in would result. With an
increase in government spending and public sector investment, there would be increase in national income
by multiple amount due to multiplier effect. For example, when marginal propensity to consume (mpc) is
0.8, the multiplier would be 1/1-mpc =5, suggesting an increase in government spending by 1 would result
in an increase in national income by 5. With the multiplied increase in income, there would be more savings,
creating more funds available for private sector to borrow. As a result, the consumption and investment from
private sector would increase. This would mean that higher public sector spending can actually increase
private sector spending.
6. Laffer Curve
The tax revenue might not necessarily fall based upon the idea
introduced by the US economist Arthur Laffer. He stated that there
would be an optimal level of tax rate where tax revenue is maximised. If
this economy is charging over such tax rate, then a cut in tax rate would
actually increase the total revenue collected because it provides a boost
in the incentives. In the diagram, a cut in tax rate from 50% to 40%
would increase the tax revenue and enable the government to have more
funds to spend on different aspects such as infrastructure or education.
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