Week 6 Lectures 11 & 12

Fiscal Policy

Reference: Bernanke, Olekalns and Frank - Chapter 6 Key Issues

• Fiscal policy and output gaps

• Effects of different fiscal instruments

• Limitations of fiscal policy

• Fiscal policy and demographics

• Public debt and government budget constraint

2

Fiscal Policy Components to fiscal policy:

• Government expenditure: current goods and services, investment and infrastructure

• Taxes (direct, indirect) – income taxes, consumption taxes

• Transfer payments – benefits, pensions Government decisions about these variables can affect the level of output in the economy Use the Keynesian model to predict how changes in fiscal policy might affect aggregate output

3

Government Spending and Output Gaps Government purchases of goods and services are a component of PAE

NXGICPAE P +++= Government expenditure is (treated as) exogenous, so changes in G will shift the PAE line Model implies that changes in G can be used to close output gaps, i.e. to ensure *YY =

4

Increasing G to Eliminate a Negative (Contractionary) Output Gap Potential Output

PAE 45-degree line

*Y Y

5

Increasing G to Eliminate a Negative (contractionary) Output Gap Potential Output

PAE 45-degree line

1PAE eY *Y Y Output gap < 0

6

Increasing G to Eliminate a Negative (contractionary) Output Gap Potential Output

PAE 45-degree line

newPAE

1PAE ∆� eY *Y Y Output gap < 0

7

Taxes, Transfers and PAE Governments make decisions about the level and types of taxes and transfer payments made in the economy. Recall:

Transfer payments are not part of G (since the government does not receive any goods and services in return). Taxes and transfers only have an indirect effect on PAE

8

Taxes, Transfer Payments and Disposable Income Taxes and transfer payments affect the level of disposable income (Y – T) received by the private sector.

• Tax cuts and increases in transfer payments will increase disposable income. When disposable income rises, PAE will rise.

• Tax increases and decreases in transfer payments will decrease disposable income. When disposable income decreases, PAE will decrease.

9

Equation for PAE in 4-Sector Model

NXGICPAE P +++= YtcTcCC )1( −+−= YtmTmM )1( −+−=

MXNX −= (Lots of substitution and collecting terms gives)

YtmcXGITmcCPAE P )1)((])([ −−++++−−=

Government can change:

• the exogenous part of taxes and transfers T

• the tax rate t

10

Increasing the Tax Rate t to Eliminate a Positive (Expansionary) Output Gap

YtmcXGITmcCPAE P )1)((])([ −−++++−−= The slope of the PAE curve is given by )1)(( tmc −− and depends on t. What is the effect of an increase in t? Let c=0.8 and m=0.2, if

• t=0.3 slope of PAE = (0.8-0.2)(1-0.3) = 0.42

• t=0.4 slope of PAE = (0.8-0.2)(1-0.4) = 0.36 Larger t gives rise to a flatter PAE

11

Increasing the Tax Rate to Eliminate a Positive (expansionary) Output Gap Potential Output

PAE 45-degree line

1PAE *Y eY Y Output gap > 0

12

Increasing the Tax Rate to Eliminate a Positive (expansionary) Output Gap Potential Output

PAE 45-degree line

1PAE newPAE *Y eY Y Output gap > 0

13

Fiscal Multipliers in the 4-Sector Model We have derived equilibrium GDP as;

])([)])1)([(1(

1XGITmcC

tmcY Pe +++−−

−−−=

Change in G: )])1)([(1(

1

tmcG

Y e

−−−=

∆

∆

Change in T : )])1)([(1(

)(

tmc

mc

T

Y e

−−−

−−=

∆

∆

14

Which has the Larger Effect on GDP an Exogenous Tax Cut or an Increase in Government Spending? Let c=0.8, m=0.2 and t=0.3 and TG ∆−=∆ Increase in G:

GGGY e ∆×=∆×=∆×−−−

=∆ 72.158.0

1

)]3.01)(2.08.0[(1(

1

Cut in T :

TTTY e ∆×=∆×=∆−×−−−

−−=∆ 03.1

58.0

6.0)(

)]3.01)(2.08.0[(1(

)2.08.0(

Government spending multiplier is larger (1.72 vs. 1.03)

15

Balanced Budget Multiplier Budget Surplus (Deficit) = T – G Consider equal changes in G and T so that (initial) level of budget surplus is unchanged. Increase government spending by 100 and simultaneously increase exogenous taxes by 100. Real world example: EU’s Growth and Stability Pact (1997) recommends its members to keep budget deficit under 3% (During crisis, GR 14%, PT 9%, IR 14%, UK 13%, SP 11%)

16

Balanced Budget Multiplier TG ∆=∆

])([)])1)([(1(

1XGITmcC

tmcY Pe +++−−

−−−=

])([)])1)([(1(

1GTmc

tmcY e ∆+∆−−

−−−=∆

Gtmc

mcY e ∆×

−−−

−−=∆

)])1)([(1(

)(1

17

Balanced Budget Multiplier (BBM) Let c=0.8, m=0.2 and t=0.3

GGY e ∆×=∆×−−−

−−=∆ 69.0

)])3.01)(2.08.0[(1(

)2.08.0(1

BBM 69.0=∆

∆

G

Y e

In the 4-sector model, BBM is positive but less than one in value.

18

The Role of Fiscal Policy in Stabilising the Economy Effects of fiscal policy occur in 2 ways: Discretionary fiscal policy

• refers to deliberate changes in the level of government spending, transfer payments or in tax rates e.g. one-off payments of up to $900, so called ‘cash splash’ in 08.

Automatic stabilisers

• refers to the tendency for a system of taxes and transfers which are related to the level of income to automatically reduce the size of GDP fluctuations

19

Discretionary Fiscal Policy Can be Relatively Inflexible

• To be useful as a stabilization tool, discretionary changes in fiscal policy need to be implemented in a timely manner (i.e. no point in increasing government spending just when the recession is over and economy is in an expansion).

• Most changes in fiscal policy are only made on an annual basis in a Government’s Budget (in Australia Federal Budget is brought down in May)

20

• In practice changing government spending or taxes typically involves a lengthy legislative process (in Australia the Budget needs to be passed by both the House of Representatives and the Senate)

• Ideally, macroeconomic policy should be forward-

looking, e.g. fiscal policy changes made today should be designed to influence future (forecast) levels of output

21

Implication:

Prior to current Global Financial Crisis (GFC), the importance of fiscal policy as a (discretionary) policy instrument for stabilizing the economy had been declining. Quote from BOF (page 186) “Fiscal policy is not often used as a stabilisation tool”

22

What was different about GFC?

• Falls in GDP were preceded by a financial/credit crisis (provided advanced warning for governments)

• Many countries (not Australia) have had relatively large and persistent falls in GDP.

• Concerns about the ability of monetary policy to provide sufficient stimulus to economies

Provided scope for governments to use fiscal policy

23

Automatic Stabilisers System of taxes and transfer payments that act as automatic stabilisers for the economy

• As GDP declines, the level of taxes paid falls and the level of transfer payments made increase.

)( GDPTT ↓=↓ implies decline in budget surplus

• This happens automatically (without any government action) and makes contractions and expansions in GDP smaller than they would have been otherwise.

24

Impact of Automatic Stabilisers GDP Impact of Automatic Stabilisers Time

25

Structural vs. Cyclical Changes in Budget Discretionary fiscal policy equated with structural changes in the budget Automatic stabilisers drive cyclical changes In response to the GFC:

• observe a cyclical decline in the budget balance (mostly due to decline in T) as automatic stabilisers work, and

• a structural decline due to big discretionary increases in G and reductions in T

26

Automatic Stabilisers (Cyclical) and Discretionary (Structural) Components of Change in Fiscal Balance

-5

-4

-3

-2

-1

0

1

2

3

-5

-4

-3

-2

-1

0

1

2

3

01/02 03/04 05/06 07/08 09/10 11/12

%GDP%GDP

∆ Structural balance

∆ Cyclical balance

∆ Total balance

Contractionary

Expansionary

27

Supply-Side Effects of Fiscal Policy Fiscal policy can affect potential output Y* as well as planned aggregate expenditure. Government investment spending on infrastructure such as roads, airports and schools can play a major role in the growth of potential GDP. However investments should provide a satisfactory economic rate of return. Avoid “white elephants”

28

Incentive Effects of Taxes and Transfers Taxes and transfer payments play a role in affecting incentives and economic behaviour Taxes on labour

• income rate rates and structure of government payments can influence labour supply decisions

Taxes on capital

• company tax rates can influence firms’ investment decisions and affect the level of private capital

29

Break-up of Australian Fiscal Stimulus Response to GFC (Feb 2009)

$42 billion Nation Building and Jobs Plan (In 2009, total govt expenditure was $340 billion)

• $29 billion for investment (70% of total stimulus) a. $14.7 billion – primary/secondary school infrastructure and maintenance, trade training centres

b. $6.6 billion – community housing, defence housing

c. $3.9 billion – insulation & solar hot water

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d. $890 million – regional roads, local govt infrastructure

e. $2.7 billion – small business tax break

• $12.7 billion in current spending – tax bonus, back to school bonus

Might have supply-side or productivity enhancing effects; in addition to standard multiplier effects predicted by the Keynesian model (more of Neo-classical or Supply side models, not dealt in this textbook)

31

Fiscal Policy and Public Debt

Budget Surplus (Deficit) = T – G

• Budget surplus/deficit is a flow variable

• Budget deficits need to be financed in some manner (eg. In 2009, T=$290 billion, G=$340 billion)

• A common source of financing is to borrow from the private sector.

32

Public Debt The outstanding stock of government borrowing is called public debt. Public debt equals the sum of all past deficits less any surpluses. (Budget deficit adds to the stock of debt, while surplus lowers the stock of debt.)

33

Budget Balance and Net Government Debt for Australia

-6

-4

-2

0

2

4

6

8

20

05

-06

20

06

-07

20

07

-08

20

08

-09

20

09

-10

20

10

-11

20

11

-12

20

12

-13

20

13

-14

20

14

-15

% o

f G

DP

Budget balance Net debt

34

Budget Deficits and (Gross) Public Debt (% GDP) 2007 2009 2010 2014 Australia Deficit 1.5 -4.3 -5.3 -1.1 Debt 9.8 16.9 22.7 27.8 US Deficit -2.8 -12.5 -10.0 -6.7 Debt 61.9 84.8 93.6 108.2 Japan Deficit -2.5 -10.5 -10.2 -8 Debt 187.8 218.6 227 245.6

35

Government Budget Constraint Means of relating government outlays (purchases and transfer payments) to their method of financing is via the government budget constraint. A government can fund its outlays in 3 ways:

• Taxes

• Borrowing (i.e. it can sell a government security)

• Printing Money

Last approach has bad reputation – associated with hyperinflation (monthly inflation greater than 50%)

36

Printing Money

Government is unable to raise sufficient revenue to cover its expenditure and runs a budget deficit Cannot borrow enough from public or from abroad to finance its deficit

Only other source of funds is the central bank, and these are provided in the form of new currency (printing money) Zimbabwe provides a recent example of the problem

37

Government Budget Constraint: Notation

tG = government purchases

tQ = transfer payments

tT~= taxes

1−tB = stock of government securities (i.e. public debt) at the end of period (t-1)

=−1trB real interest payments on public debt Note: The above notation separates taxes and transfer

payments. In term of our previous notation ttt QTT −=~

.

38

Government Budget Constraint Government expenditures (purchases, transfer payments and interest payments) in any period needs to be funded by taxes or by borrowing. (Assume no money printing.)

11

~−− −+=++ tttttt BBTrBQG

Re-arranging

11

~−− −=−++ tttttt BBTrBQG

When the Govt runs a deficit budget, the left-hand side is positive, and we will be adding to the stock of public debt. (Public debt will fall with a budget surplus).

39

Costs of Public Debt Crowding Out: High levels of government borrowing may raise real interest rates and this will tend to crowd-out private investment and capital formation (see S & I model from Week 2). Intergenerational Equity: Borrowing because of deficit budgets can’t be sustained forever, and eventually surpluses would be required to reduce debt. Intergenerational equity means we should not enjoy the benefits of budget deficits now and pass on the costs of those deficits to future generations.

40

Benefits of Public Debt One use of public debt is to finance the provision of public infrastructure. Where infrastructure has the characteristics of a public good it will be under-supplied by the private sector. Some estimates suggest that the returns to investment in infrastructure are relatively high. Thus it is possible that public debt may have a net benefit for the economy, even when allowing for crowding out and intergenerational equity effects.

41

Fiscal Policy Challenges – Demographic Change Australia’s population is expected to increase from 20.5 million in 2006 to 24.5 million in 2048. Declining fertility rates and increased longevity means that people 65 and over are likely to go from 13% of the population to 22% in that time. This has implications for Government expenditure, as health, aged care and pension spending will increase over that time.

42

Australia’s Population is Projected to Age, Despite Immigration

0

10

20

30

40

50

0

15

30

45

60

75

0-14 15-64 65-84 85+

1971

2006

2021

2051

Median age 1971;2006;2021;2051

% share Age

ABS Cat 3222.0

September 2008 – ‘B’

projections

43

44

What About Future Tax Revenues? Difficult to forecast. Depends on;

• Tax rates

• Size of labour force

• Growth rate of GDP Suppose we assume that Government revenue as a proportion of GDP will remain at about 22%. Projection then sees large deficits from about 2025 onwards.

45

46

What to do? 2009 budget increased pension age from 65 to 67

– However, pension age is not retirement age – Can access superannuation at 55 or 60 (some incentives for wait till 60) and retire – Current average retirement age is less than 60

• Other measures to increase actual retirement age – allow age at which one can access super to rise to 67?

• Start working earlier? E.g. Consider cost vs. benefit of long education. • OR Increase taxes

47

Distribution of Income A key function of fiscal policy is to influence the distribution of income between households in the economy. This is done by influencing the total disposable income available to households, through net taxes. Net taxes = tax paid by a household less transfer payments received.

48

Progressive Taxes Australia has a system of progressive income taxes. The higher the income earned by the household, the relatively higher proportion of tax is paid on that income. Example:

• Income of $120,000 is taxed $35,850 which is 29.9% average tax rate

• A household earning $60,000 is taxed $13,350 which is 22.3% average tax rate.

49

Progressive Taxes and Transfer Payments The proportion of income paid as tax is higher at higher income levels. This results in a less unequal distribution of income than would be the case if the income tax rates were not progressive. Government transfer payments are also targeted toward low income earners and “means tested”. These payments also narrow the gap that would otherwise be.

50

Measuring Inequality: Lorenz Curve Perfect Income Equality 100 Proportion of PeP Income % 50 0 0 50 100 Proportion of Households %

51

Measuring Inequality: Lorenz Curve Income Equality 100 Proportion of PeP Income % 50 30 0 0 50 100 Proportion of Households %

52

Measuring Inequality: Gini Coefficient Summary statistic for income inequality Area between line of equality and Lorenz Curve Gini = Total area below line of equality Gini = 0 is perfect income equality. Higher Gini means higher income inequality

53

Increasing Income Inequality in Australia Year Gini coefficient 1985 0.292 1995 0.308 2003 0.312 Gini has been rising over time Who is better and who is worse? US (2000) 0.368 Sweden (2000) 0.252