Chapter 13: Fiscal Policy

Question 1

What is fiscal policy (discretionary fiscal policy)?

Answer 1

This refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability and healthy rates of economic growth. Do not mix this up with automatic stabilisers.

Question 2

What is fiscal policy usually referred to by economists?

Answer 2

They typically use the term to refer only to the actions of the federal government, even though state and local governments also have responsibility for taxing and spending.

Question 3

Are all federal government tax and spending decisions fiscal policy actions?

Answer 3

No, they because they are not all intended to achieve macroeconomic policy goals.
e.g. a decision to cut the taxes of people who take out private health insurance is a health policy action, not a fiscal policy action.

Question 4

What are automatic stabilisers?

Answer 4

Transfer payments and taxes that automatically increase or decrease along with the business cycle. As a result, these changes in these types of spending and taxes happen without actions by the government.

e. g. when the economy is expanding and employment is increasing, government transfers for unemployment benefit payments to workers who were previously unemployed will automatically decrease and vice versa.
e. g. when the economy is expanding or experiencing an economic boom and incomes are rising, the amount the government collects in taxes will increase as people pay additional taxes on their higher incomes and vice versa.

Question 5

Is there a difference between government purchases and government expenditures?

Answer 5

Yes.
Purchases example: the federal government funds the building of a motorway or purchases the services of a university, it receives goods and services in return
Expenditures example: federal government expenditures include purchases plus all other federal government spending.

Question 6

Can fiscal policy be used to influence aggregate demand?

Answer 6

Yes, the federal government can use it to offset the effect of the business cycle or an economic shock in the economy. When the economy is experiencing an economic contract or recession, increases in government purchases or decreases in taxes will increase AD. The inflation rate may also increase of AD increases faster than AS. However, decreasing government purchases or raising taxes can slow the growth of AD and reduce the inflation rate.

Question 7

What is expansionary fiscal policy?

Answer 7

Increases in government purchases or decreases in taxes in order to increase AD.

Question 8

How does an increase in government purchases increase AD?

Answer 8

An increase in government purchases will increase AD directly because government purchases are a component of AD.

Question 9

How does a decrease in taxes increase AD?

Answer 9

Because it increases the amount of disposable income (income after tax) households have. This will lead to an increase in consumption spending. Similarly, tax cuts on business income can increase AD by increasing business investment.

Question 10

Explain the effect of expansionary fiscal policy on the dynamic AD and AS model.

Answer 10

Overtime potential GDP increases – shown by the LRAS curve shifting to the right
The factors that also cause the LRAS to shift also cause firms to supply more goods and services at any given price level in the short run = SRAS curve shift to the right
Finally, during most years, the AD curve also shifts to the right, indicating that aggregate expenditure is higher at every price point (this indicates the use of expansionary fiscal policy to meet LRAS and SRAS at an equilibrium).

This results in the equilibrium price level increasing = inflation rate is higher than it would have been if expansionary fiscal policy had not been used.

Question 11

What is contractionary fiscal policy?

Answer 11

This refers to decreases in government purchases or increases in taxes in order to reduce the increases in AD (as these are likely to increase the rate of inflation without intervention).

Question 12

Explain the effect of contractionary fiscal policy on the dynamic AD and AS model.

Answer 12

Y axis = price level
X axis = real GDP 
LRAS1 = vertical line intersecting with AD1 and SRAS1 (equilibrium A)
AD1 = diagonal downward sloping line
SRAS1 = diagonal upward sloping line

LRAS2 = shifts to right of LRAS1
AD2(without policy) = shifts to the right of AD1 (due to LRAS increasing)
SRAS2 = shifts to right of SRAS1 (this results in a short-run macroeconomic equilibrium beyond potential GDP – point B)
Point B = intersection between SRAS2 and AD2(without policy) (higher price level and higher GDP than point A and C)

= increase in price level

Decreasing government purchases or increasing taxes will shift AD1 and/or AD2(without policy) to AD2(with policy) and keeps real GDP from moving beyond its potential level.

AD2(with policy) = downward sloping line in between AD1 and AD2(without policy). It intersects with LRAS2 and SRAS2 to create equilibrium point C.

Point C = price level and GDP level in between point A and B.

Question 13

Summarise countercyclical fiscal policy.

Answer 13

Problem – Type of Police – Actions by the Government - Result
Economic contraction or recession = expansionary = increase gov spending or cut taxes = real GDP and price level rise by more than they would have without policy.

Rising inflation rate = contractionary = decrease government spending or raise taxes = real GDP and the price level does not rise by as much as they would have without policy.

Question 14

What is the multiplier effect?

Answer 14

The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

Question 15

What is autonomous expenditure?

Answer 15

Economists refer to the initial increase in government purchases as autonomous because it was the result of a decision by the government and does not directly depend on the level of real GDP. The increases in consumption spending are induced by the initial increase in autonomous spending.

Question 16

Explain the multiplier’s effect on AD.

Answer 16

An initial increase in government purchases causes the AD curve to shift from the right from AD1 to AD2 and represents the impact of the initial increase in $x billion government purchases. Because this initial billion raises incomes and leads to further increases in consumption spending, the AD curve will shift further to the right, to AD3.

Question 17

What is the government purchases multiplier?

Answer 17

The ratio of change in equilibrium real GDP to the initial change in government purchases.
Government purchases multiplier = change in equilibrium real GDP/change in government purchases

Although we cannot say precisely how many periods it will take, we simply label the final period, n, rather than giving it a specific number.

Question 18

Is the multiplier a short-run or long-run effect?

Answer 18

The multiplier has a short-run effect that assumes that the economy is below the level of potential GDP. In the long-run, the economy is at potential GDP, so an increase in government purchases causes a decline in the non-government components of real GDP, but it leaves the level of real GDP unchanged.

Question 19

Do tax cuts have a multiplier effect?

Answer 19

Yes. Cutting personal income taxes increases the disposable income of households. When household disposable income rises, so will consumption spending, depending on the size of the MPC. These increase in consumption spending will set off further increases in real GDP and income, just as increases in government purchases do.

Question 20

What is the tax multiplier expression?

Answer 20

Tax multiplier = change in equilibrium real GDP/changes in taxes.

The tax multiplier effect is a negative number because changes in taxes and changes in real GDP move in opposite directions: an increase in taxes reduces disposable income, consumption and real GDP. And a decrease in taxes raises disposable income, consumption and real GDP.

Therefore, the first period of the multiplier process will lead to a smaller increase in AD than what occurs when there is an increase in government purchases, and the total increase in equilibrium real GDP will be smaller.

Question 21

What is the effect of changes in tax rates?

Answer 21

A change in tax rates has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount. To begin with, the value of the tax rate affects the size of the multiplier effect. The higher the tax rate, the smaller the multiplier effect. This is because a higher tax rate causes a smaller amount of increase in income which households have available to spend, which reduces the size of the multiplier effect.

Question 22

What are the 2 channels in which a cut to tax rates affects equilibrium real GDP?

Answer 22

1. A cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending and
2. A cut in tax rates increases the size of the multiplier effect.

Question 23

What is the multiplier effect on aggregate supply?

Answer 23

An increase in government purchases causes the AD curve to shift to the right. From AD1 to AD2. The multiplier effect results in the AD curve shifting further to the right, to AD3 (Point B). Because of the upward sloping supply curve, the shift in AD results in a higher price level. In the new equilibrium at point C, both real GDP and the new price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level.

Question 24

Do decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP?

Answer 24

Yes, but in these cases the effect is negative.
e.g. an increase in taxes will reduce household disposable income and consumption spending. As households buy less furniture, cinema tickets and other products, the firms that sell these products will cut back on production and begin laying off workers. Falling incomes will lead to further reductions in consumption spending. A reduction in government spending on reads would set off a similar process of decreases in real GDP and income. The cutback would be felt first by construction contractors selling goods and services directly to the government, and then it would spread to other firms.

Question 25

What are the limits to using fiscal policy to stabilise the economy?

Answer 25

• Getting the timing right.

- Crowding out

Question 26

What is the affect of poorly timed fiscal policy?

Answer 26

Like poorly timed monetary policy, it can do more harm than good. It takes time for policy-makers to collect statistics and identify changes in the economy and it can also take a substantial amount of time for the government to formulate policy and get it passed through parliament.

Question 27

Why is timing more difficult to get right for fiscal policy than for monetary policy?

Answer 27

Because control over monetary policy is concentrated in the hands of the RBA board, which can change monetary policy at any of its monthly meetings or at any other time by calling a special meeting whereas control over fiscal policy involves the government and parliament (both houses) having to agree on changes.

Question 28

Does government spending reduce private spending?

Answer 28

We have been assuming that when the federal government increases its purchases by $x billion, the multiplier effect will cause the increase in AD to be greater than $x billion. However, the size of the multiplier effect may be limited if the increase in government purchases causes one or more of the non-government, or private, components of aggregate expenditures (C, I or net Exports) to fall = crowding out).

Question 29

What is crowding out?

Answer 29

A decline in private expenditure as a result of an increase in government purchases.

Question 30

What does the federal government’s budget show?

Answer 30

The relationship between its expenditures and its tax revenue.

Question 31

What is a budget deficit?

Answer 31

The situation in which the government’s expenditures are greater than its tax revenue. If the commonwealth government has a budget deficit this has to be financed by borrowing. This borrowing contributes to the net debt of the commonwealth government.

Question 32

What is a budget surplus?

Answer 32

The situation in which the government’s expenditures are less than its tax revenue.

Question 33

What is net debt?

Answer 33

This is the difference between the amount of funds the government borrows and the amount it lends.

Question 34

How does the federal budget serve as an automatic stabiliser?

Answer 34

Because the federal budget deficit increase during economic contractions and recessions because of discretionary fiscal policy actions. Discretionary increases in spending or cuts in taxes to increase AD will increase the budget deficit. Federal budget deficits also occur during contractions or recessions without the government taking action because of the effects of the automatic stabilisers.

Question 35

Why do deficits occur automatically during a contraction or recession?

Answer 35

Because:

• The rate of growth of wage income and profit falls, causing government tax revenues to grow slowly or even fall
• And the government automatically increases transfer payments as more people become unemployed when the economy contracts or moves into recession

Question 36

What is structural budget deficit or surplus?

Answer 36

The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

Question 37

Explain how the level of GDP affects the structural budget deficit.

Answer 37

Suppose the federal budget is balanced at potential GDP of $2 trillion. If real GDP is above $2 trillion, where will be a budget surplus. If real GDP is below $2 trillion, there will be a budget deficit.

Figure 13.1:
Y-axis = budget surplus or deficit (trillions) of dollars
X-axis = real GDP
LRAS = Vertical line in middle of plane
Budget line = upward sloping line at an acute angle with the x-axis
Intersection = LRAS, Budget line and the x-axis (at point $2 trillion)
Space between budget line and real GDP = deficit or surplus area (depending on whether the budget line is below or above the x-axis)

Question 38

Should the federal budget always be balanced?

Answer 38

Although many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP, few economists believe that the federal government should attempt to balance the budget every year. This is because, for example, during a contraction or recession the federal budget automatically moves into deficit. To bring the budget back not balance, the government would have to increase taxes or reduce spending, but these actions would reduce AD, thereby making the contraction or recession worse by slowing down economic growth. Similarly, when real GDP increases above its potential level, the budget automatically moves into surplus.

Question 39

Is debt a government problem?

Answer 39

No, not necessarily. At times government debt may be necessary. During an economic contraction or a recession, automatic stabilisers and expansionary fiscal policy will lead to a budget deficit and therefore government debt. Furthermore, if a government is embarking on major infrastructure projects to promote increased economic growth in the future (such as roads, railways and improved air and sea ports), borrowing may be required.

However, debt can be a problem for a government for the same reasons that it can be a problem for a household or a business. If a family is unable to make debt payments, it will have to default on the loan. The federal government in Australia is in no danger of defaulting on its debts. Ultimately, the government can raise funds it needs through taxes to make the interest payments on its debts.

Question 40

What happens if the debt becomes very large relative to the economy?

Answer 40

The government will have t raise taxes to high levels or cut back on other types of spending to make the interest payments on the debt.

Question 41

Is there an opportunity cost involved in servicing debt?

Answer 41

Yes, in terms of the interest repayments that must be made that could have been used for other expenditures. Furthermore, crowding out of private investment spending may occur.

Question 42

What is the effect of crowding out?

Answer 42

Lower private sector investment spending means a lower capital stock in the long run and a reduce capacity of the economy to produce goods and services and employ people. This effect is somewhat offset if some of the government debt is incurred to finance improvements in infrastructure, education or to R&D. Improvements in infrastructure, a better educated labour force and additional R&D can add to the productive capacity of the economy.

Question 43

What are the effects of fiscal policy in the long-run?

Answer 43

Fiscal policy actions intended to have long-run effects aim to expand the productive capacity of the economy and increase the rate of economic growth. These policy actions primarily affect aggregate supply rather than AD and are referred to as supply-side policies.

Question 44

What are supply-side policies?

Answer 44

Fiscal policies that have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. These policy actions primarily affect AS rather than AD, shifting the LRAS curve to the right.

Supply-side policies also include increasing productivity through new technology and education, increasing the size of the labour force and microeconomic reforms to increase economic efficiency.

Most fiscal policy actions that attempt to increase AS do so by changing taxes to increase the incentives to work, save, invest and start a business.

Question 45

What is a tax wedge?

Answer 45

The difference between the pre-tax and post-tax return to an economic activity. The tax wedge applies to the marginal tax rate. In general, economists believe that the smaller the tax wedge for an economic activity – such as working, saving, investing or starting a business – the more of that economic activity will occur.

Question 46

What is the marginal tax rate?

Answer 46

The fraction of each additional dollar of income that must be paid in taxes.

Question 47

What is the effect on AS from cutting individual income tax?

Answer 47

Reducing the marginal tax rates on individual income will reduce the tax wedge faced by workers, thereby increasing the quantity of labour supplied. Many small businesses are sole proprietorships, whose profits are taxed at the individual income tax rate. Therefore cutting/reducing the individual income tax rates:

• raises the return to entrepreneurship, in turn encouraging the opening of new businesses and
• increases the return to saving.

Question 48

What is the effect on AS from cutting company income tax?

Answer 48

Cutting the company income tax rate would encourage investment spending by increasing the return corporations receive from new investments in equipment, factories and office buildings. Because innovations are often embodied in new investment goods, cutting company income tax potentially can increase the pace of technological change.

Question 49

What is the effect on AS from cutting taxes on capital gains?

Answer 49

Individuals pay taxes on capital gains (although the tax on capital gains can be postponed if the shares are not sold). As a result, the same earnings are, in effect, taxed twice: once when corporations pay the company income tax on their profits, and again when the profits are received by individual investors in the form of capital gains.

With the company income tax remaining in place, one way to reduce the ‘double taxation’ problem is to reduce the taxes on capital gains. Lowering the ax rates on capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate.

Question 50

What is company income tax?

Answer 50

It is the tax the federal government imposes on the profits earned by corporations.

Question 51

What is a capital gain?

Answer 51

This is the change in the price of an asset, such as a share of stock.

Question 52

What are dividends?

Answer 52

The distribution of profits to shareholders. Shareholders may also benefit from higher corporate profits by receiving capital gains. Rising profits usually result in rising share prices and capital gains to shareholders.

Question 53

Are there gains from tax simplification?

Answer 53

Yes, in addition to the potential gains from cutting individual taxes, there are also gains from tax simplification. If tax law were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. Simplified taxation rules would increase economic efficiency by reducing the number of decisions made by households and firms solely to reduce their tax payments.

Question 54

What are the losses from tax complexity?

Answer 54

If tax law were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. In addition to wasting resources, the complexity of tax law may also distort the decisions taken by households and firms. Simplified taxation rules would increase economic efficiency by reducing the number of decisions made by households and firms solely to reduce their tax payments.

Question 55

What is the economic effect of tax reform?

Answer 55

Y-axis = price level
X-axis = Real GDP
LRAS1 = vertical line, most left
LRAS2 = in between LRAS1 and LRAS3
LRAS4 = most right
AD1 = downward sloping line intersecting with LRAS curves at points A, B and C respectively

Without tax changes, the LRAS curve will shift from LRAS1 to LRAS2
- This shift reflects the increases in the labour force and the capital stock and the technological change that would occur even without tax reduction and simplification

To focus on the impact of tax changes on AS, we will ignore the SRAS curve and will assume that the AD remains unchanged at AD1.
- In this case, equilibrium moves form point A to B with Real GDP increasing from Y1 to Y2 and the price level decreasing from P1 to P2.

With tax reductions and simplifications, the LRAS curve shifts further to the right to LRAS 3 and the equilibrium moves to point C, with the price level falling to P3 and real GDP increasing to Y3.

We can conclude that a successful policy of tax reductions and simplifications will benefit the economy by increasing the output and employment and, at the same time, may result in smaller increases in price level (however, not all economists would agree with this conclusion).

Question 56

What are the supply-side effects to reducing taxes?

Answer 56

Decreasing marginal income tax rates will increase the quantity of labour supplied, cutting the company income tax will increase investment spending, and so on.

Some economists argue that the increase in the quantity of labour supplied following a tax cut will be limited because many people work a number of hours set by their employers and lack the opportunity to work additional hours. Similarly, some economists believe that tax changes have only a small effect on saving and investment.

Furthermore, there are economists who are sceptical of the magnitude of supply-side effects and believe that tax cut have their greatest impact on AD, rather than on AS. In their view, focusing on the impact of tax cuts on AD, while ignoring any impact on AS, yields accurate forecasts of future movements in real GDP and the price level, which indicates that the supply0side effects must be small.