Chapter 12 : Fiscal policy

Chapter 12: Fiscal Policy

Introduction

Fiscal policy refers to the use of government spending and taxation to influence the overall level of economic activity. This chapter explores how changes in government expenditures and taxes affect aggregate demand, the equilibrium price level, and real GDP. It also examines the effectiveness and limitations of fiscal policy, including time lags and automatic stabilizers.

12.1 Discretionary Fiscal Policy

Definition and Goals

• Fiscal policy is the discretionary changing of government expenditures or taxes to achieve national economic goals, such as:

  • High employment (low unemployment)

  • Price stability

  • Economic growth

Government Spending

• An increase in government spending stimulates economic activity by raising aggregate demand.

• Examples of government spending include health care, education, and agency budgets.

Expansionary and Contractionary Fiscal Policy

• Expansionary fiscal policy involves increasing government spending or decreasing taxes to boost aggregate demand.

• Contractionary fiscal policy involves decreasing government spending or increasing taxes to reduce aggregate demand.

Figure: Expansionary and Contractionary Fiscal Policy

Expansionary policy shifts the aggregate demand curve rightward, increasing real GDP and the price level. Contractionary policy shifts the aggregate demand curve leftward, decreasing real GDP and the price level.

Tax Changes

• A rise in taxes reduces aggregate demand by decreasing consumption, investment, and net exports.

Figure: Fiscal Policy and Taxes

Tax reductions can move the economy from below full employment to equilibrium, while tax increases can reduce inflationary pressures.

12.2 Possible Offsets to Fiscal Policy

Key Questions

• How are expenditures financed, and by whom?

• What does the government do with increased tax revenues?

• How do expectations of future taxes affect current behavior?

Crowding-Out Effect

• Crowding-out effect: Expansionary fiscal policy may decrease private investment or consumption due to higher interest rates.

• This effect can partially offset the intended stimulus of fiscal policy.

Figure: The Crowding-Out Effect (Step by Step)

Step	Description
1	Government increases spending, needs funds
2	Government borrows from savers
3	Interest rates rise to attract more funds
4	Higher interest rates discourage private investment
5	Private sector spending decreases

Ricardian Equivalence Theorem

• Proposes that an increase in the government budget deficit has no effect on aggregate demand.

• Reason: People anticipate higher future taxes and adjust their spending accordingly.

Permanent Income Hypothesis

• States that current consumption depends on anticipated lifetime income.

• Temporary tax cuts have minimal effect on total consumption spending.

Direct Expenditure Offsets

• Private sector actions may offset government fiscal policy, especially when government spending competes with private sector spending.

Supply-Side Effects of Tax Changes

• Reducing marginal tax rates can increase productivity, work effort, saving, and investment.

• Higher productivity leads to economic growth and higher real GDP.

• Lower marginal tax rates may not reduce tax revenues if the tax base expands.

• The relationship between tax rates and tax revenues is illustrated by the Laffer Curve.

Figure: Laffer Curve

Tax Rate	Tax Revenues
Low	Low
Moderate	High
High	Low

The Laffer Curve shows that tax revenues initially rise with higher tax rates but eventually decline as rates become excessive.

Recession and the Laffer Curve

• During a deep recession, taxable real income falls, making the Laffer curve shallower.

• Governments collect fewer tax revenues at any given tax rate.

12.3 Discretionary Fiscal Policy in Practice: Coping with Time Lags

Time Lags in Fiscal Policy

• Recognition time lag: Time needed to gather information about the economy's current state.

• Action time lag: Time between recognizing a problem and implementing policy.

• Effect time lag: Time between policy implementation and observable results.

Implications of Time Lags

• Time lags are often long (one to three years) and variable.

• This variability makes it difficult for policymakers to fine-tune the economy.

12.4 Automatic Stabilizers

Definition and Examples

• Automatic stabilizers are built-in government programs that adjust aggregate expenditures without new government action.

• Examples include the progressive federal tax system and government transfers (e.g., employment insurance).

The Tax System as an Automatic Stabilizer

• When incomes and profits fall, tax revenues drop, acting as an automatic tax cut and stimulating aggregate demand.

Government Transfers

• Employment insurance payments help stabilize aggregate demand by maintaining disposable income during unemployment.

• Income transfer payments increase during recessions, moderating the drop in disposable income.

• Example: The Canadian government introduced CERB during COVID-19 to support incomes.

Stabilizing Impact

• Automatic stabilizers mitigate changes in disposable income, consumption, and equilibrium GDP.

• If disposable income does not fall as much during a recession, the downturn is moderated.

Figure: Automatic Stabilizers

Real GDP per Year	Tax Revenues	Government Transfers	Budget Surplus/Deficit
Low	Low	High	Deficit
High	High	Low	Surplus

Issues & Applications

Assessing Overall Effects of Discretionary Fiscal Policy

• Discretionary changes in spending and taxes may shift aggregate demand in the same or opposite directions.

• Net effects must be assessed to determine the overall impact on aggregate demand.

• Example: The Canadian government's fiscal response to COVID-19 aimed to stabilize the economy.

Summary of Learning Objectives

• Keynesian analysis: Increases in government spending and decreases in taxes raise aggregate demand; the reverse lowers it.

• Offsets: Crowding-out, direct expenditure offsets, and Ricardian equivalence can reduce fiscal policy effectiveness.

• Time lags: Recognition, action, and effect lags are long and variable, complicating policy fine-tuning.

• Automatic stabilizers: Built-in mechanisms minimize reductions in planned expenditures during downturns.

Additional info:

• The chapter provides Canadian and international examples, such as CERB and Italy's flat tax proposal, to illustrate fiscal policy concepts.