Fiscal Policy

Question 1

What is the Federal Budget?

Answer 1

The Federal Budget, delivered in Parliament in May of each year, estimates government revenue and the cost of expenditure plans for the coming year.

Question 2

What was estimated revenue, expenditure and budget balance in 2016-17?

Answer 2

Estimated revenue in 2016-17 was $411.3 billion.
Forecast expenditure in excess of $450.6 billion.
Expenditure is greater than revenue, so the government was expecting to run a budget deficit of $39.2 billion.

Question 3

What are the major sources of revenue and expenditure?

Answer 3

Major source of revenue:
Individuals income tax, company tax, sales tax.

Major sources of expenditure:
Social security and welfare, health, education and defense.

Question 4

What are the three possible budget outcomes?

Answer 4

Surplus- total revenue is greater than outlays (expenditure).
Deficit- spending exceeds revenue.
Balance- if planned revenue and expenditure are equal.

Question 5

Why is it important to consider the budget in relation to the previous year’s budget outcome?

Answer 5

The outcome of the budget really depends NOT on its absolute value (i.e. deficit or surplus), but on its value relative to the actual outcome last year.
e.g.
Budget deficit 16/17= $39 bn
Budget deficit 17/18= $37 bn

Question 6

What are exogenous factors and how might they effect the budget outcome?

Answer 6

Exogenous factors (events not related to budget processes such as exchange rate movements, rapid changes in the ToT, or non-economic events), may also cause the actual outcome to differ from the predicted result. More government funding could be called upon in the event of major floods, droughts, or fires. These events could not necessarily have been anticipated wen compiling Budget forecasts.

Question 7

Describe the three purposes of the budget.

Answer 7

1. Decides how revenue will be raised, and allocates funds to areas of need. Budget allocation don’t change much from year to year, because they are often determined by ongoing needs e.g. education. Funding allocation is driven partly by political progress, as the government of the day needs to support its initiatives (e.g. NBN).
2. The budget redistributes income from the wealthy to the less-wealthy. The wealthy pay higher rates of income tax, and people on lower incomes receive more government support (both directly and indirectly) than those on higher incomes.
3. The government can use the budget to influence the level of macroeconomic activity (i.e. stabilize fluctuations in the business cycle). Keynes adopted interventionist economic policy, meaning governments should use fiscal and monetary measures to reduce the adverse effects of business cycles.

Question 8

Why did Keynes argue that a balanced budget could actually destabilize the economy?

Answer 8

Keynes argued that the balanced budget policy could actually destabilize the economy because government expenditure was tied to revenue. In a trough, when revenue falls, a budget balance would result in a fall in government expenditure- just the opposite of what the economy needed to boost the level of spending and output.

Question 9

How can a budget deficit be financed?

Answer 9

A budget deficit must be financed because a debt has been created which must be paid off in the future.
Three ways this can be done:
-Selling government bonds
-Borrowing from the central bank/Reserve Bank
-Borrowing from overseas

Question 10

How can the government finance a budget deficit by selling government bonds?

Answer 10

Government bonds are financial instruments which raise funds for its issuer (government). They are very safe. Consumers use surplus cash/savings to buy government bonds and earn interest. In selling bonds, the government raises money to finance its budget deficit. A large bond issue may cause an increase in interest rates across the market because government borrowing creates higher demand for credit in financial markets.

Question 11

Explain the problem of crowing out.

Answer 11

‘Crowing out’ is the increase in interest rates due to higher demand for credit. This competition (crowding out) occurs because the private sector is crowded out because of government borrowing. This causes a paradox -> government borrows to increase economic activity but increased interest rates would dampen consumption.

Question 12

What is the main advantage of the gov borrowing from the private sector?

Answer 12

The main advantage of the government borrowing from the private sector is that it does not increase the MONEY SUPPLY. The public initially withdraws money from the banking system to pay for purchases and securities. When the government spends the borrowed funds the net effect is nil.

Question 13

What is the likely consequence of the government borrowing from the RBA to finance the deficit?

Answer 13

When borrowing from the RBA it is injecting new money into the economy. This has a desired expansionary effect on the economy but will increase the money supply and is likely to have an inflationary effect.

Question 14

What is the likely consequence of the government borrowing from overseas to finance the deficit?

Answer 14

Borrowing from overseas does NOT increase the money supply under Australia’s system of a floating exchange rate, BUT the exchange rate will DEPRECIATE due to the inflow of money capital (other things being equal). Therefore, exports will be less competitive and imports will increase. This is counter effective to Budget deficit objectives.

Question 15

Explain the various ways the government can use the budget surplus funds.

Answer 15

• The surplus could be used to retire (pay off) government debt build up by past deficits, held over to funds future expenditure, or returned to taxpayers as tax cuts.
• All three happened in the mid 2000’s, when Australia was one of the few countries in the world with no public debt.
• Australia still has comparatively low debt even after the spending stimuli associated with the global economic slowdown.

Question 16

Explain the problem of crowding in.

Answer 16

There are a number of secondary effects that might counteract the original intentions of the surplus.
Retiring debt, for example, means that bond holders are repaid the capital value of their bonds, giving them extra spending power.
This has been called ‘crowding in’. Lower public debt may also raise a question about ‘intergenerational equity’- the idea that the coasts of infrastructure built today should be shared between today’s taxpayers and those who will also benefit from those facilities in the future.
That is, future taxpayers are ‘free-riding’ on current taxpayers if public debt is relatively low.

Question 17

What is the difference between the structural and cyclical component of a budget?

Answer 17

The cyclical component of the budget refers to the way in which the government revenue and expenditure is affected by the current state of the economy and the business cycle.

The structural component refers to the DELIBERATE decisions made by the government when planning expenditure and revenue and deciding whether the budget will be in deficit or surplus.

Question 18

What does the term ‘structural balance’ mean in terms of the budget balance?

Answer 18

Structural balance is an estimate of the budget balance, excluding the cyclical factors. This is important because it reveals how governments change the revenue and spending settings to achieve longer term macroeconomic policy objectives.

Question 19

How do automatic stabilisers work during a trough phase?

Answer 19

When the economy enters the trough phase of the cycle, tax revenue falls, so the budget balance moves towards deficit (or an increasing deficit).

Question 20

How do automatic stabilisers work during a boom?

Answer 20

When the economy is stronger, tax revenue rises and welfare payment fall, so the budget balance becomes increasingly positive.
As a result, income taxes and transfer payments act like an economic shock absorber. They reduce the level of aggregate spending in a boom, and increase it in a trough.
They also impact upon the budget outcome- a budget deficit will automatically increase as the economy contracts, and automatically decreases as the economy expands.

Question 21

With the use of a diagram, explain how automatic stabilisers work.

Answer 21

Tax revenue rises as GDP rises, as shown by the positively sloped line. The transfer payments line is negatively sloped, because claims on welfare fall as economic activity rises.
If we start at the Budget balance point and the economy slow, tax revenue will fall and transfer payment rise pushing the budget in to deficit and stabilizing the economy to some extent.
Alternatively, if we start at the Budget balance point and the economy expands, tax revenue rises and transfer payment fall- automatically pushing the budget towards surplus and stabilizing the economy by reducing aggregate spending power.

Question 22

Define discretionary fiscal policy.

Answer 22

The deliberate changes to expenditure and revenue that the government makes in the budget to stabilize the economy.

Question 23

Explain how discretionary fiscal policy works.

Answer 23

• In a period of low economic activity, it is appropriate to run an expansionary budget in order to stimulate spending.
• In a period of higher economic activity, it would be appropriate for the government to plan a budget surplus to reduce the growth in spending and in the economy.
• If the government thought economic conditions were close to the natural rate of employment with inflation in the 2-3% range, it might adopt a neutral budget stance.

Question 24

What are some ways the government might stimulate household and business spending?

Answer 24

• Reducing income tax to increase household purchasing power.
• Cutting corporate tax (tax on company profits) to stimulate business spending on infrastructure, such as transport and communications projects.

Question 25

Use the AE model to explain the impact of government fiscal policy during a trough.

Answer 25

In a trough, the government uses its budget to increase aggregate expenditure to counter the ‘deflationary gap’ (difference between Ydef and Yfe). A deficit budget can be achieved by cutting taxes and/or increasing government spending. The level of economic activity will rise from Ydef to Yfe. The model shows an increase in G of $25 million will cause oncome to rise by $50 million due to the multiplier effect.

Question 26

Use the AD/AS model to explain the impact of government fiscal policy in a trough.

Answer 26

Increased aggregate demand through increased aggregate spending and/or decreased taxation will have an expansionary effect in the economy. The model shows that expansionary fiscal policy shifts the AD curve from its original level of AD (in the Keynesian zone) to AD1 (in the ideal zone). The level of real output (income and expenditure) increases from Y to Y1. Expansionary fiscal policy has bought the economy closer to its potential (full employment). This policy should have minimal impact on inflation if the economy is in a trough because there is excess capacity. Price level rises from P to P1.

Question 27

What are some policy options to contract spending in a boom?

Answer 27

• Increasing income tax rates and company taxes.
• Reducing or postponing government spending on major projects..
• Increasing excise taxes such as those applied on sales of cars, tobacco and alcohol.

Question 28

Use the AE model to explain the impact of fiscal policy during a boom.

Answer 28

During a boom, the government uses its budget to counter the inflation gap (difference between YFE and Ydef). This can be achieved by raising taxes and/or decreasing government spending. The level of economic activity will fall from Ydef to Yfe. Contractionary fiscal policy reduces households’ disposable income, to they have less to spend on consumption. Company taxes could also be raised. The model shoes a decrease of G of $25 million will cause income to decrease by $50 million due to the multiplier.

Question 29

Use the AD/AS model to explain how fiscal policy works in a boom.

Answer 29

Decreased aggregate demand through decreased aggregate spending and/or increased taxation will have a contractionary effect on the economy. The model shows that contractionary fiscal policy shifts the AD curve from its original level of AD (in the classical range) to AD1 (in the ideal range). The level of real output (income and expenditure) falls from Y to Y1. Contractionary fiscal policy has bought the economy away from its potential, as to reduce inflationary pressure in the economy. The price level decreases significantly from P to P1.

Question 30

Identify and explain the three strengths of fiscal policy.

Answer 30

1. Fiscal policy is direct.
   Revenue and spending measures announced in the budget can be implemented immediately. Decisions impact on revenue and savings patters as soon as they are enacted.
2. Ifs effect on the economy in a recession.
   The government can open a ‘spending tap’ to increase the level of aggregate demand in the community.
   e.g. in the GFC, many governments adopted significant financial stimulus packages to try and avoid a recession.
3. Well-times fiscal policy measures and automatic stabilisers are complementary.
   In a boom, both discretionary and automatic stabilisers dampen spending and economic activity. In a downturn, both stimulate spending and economic activity.

Question 31

Explain the tax multiplier.

Answer 31

A change in tax must first change consumption through the MPC, whereas a change in G will directly affect GDP.
e.g.
If MPC=0.6
k= 1/0.4 =2.5

tax multiplier= MPC/MPS =0.4/0.4 =1.5

If tax is cut by $10bn, then GDP will increase by $15bn.
If G is increased by $10bn, then GDP will increase by $25bn.

Question 32

Explain the three types of lags.

Answer 32

Recognition lag
Occurs because the economic indicators that provide data about economic performance often lag the real trends (i.e. policy makers do not know about an event until after it happens).

Decision lag
Refers to the time that passes whilst appropriate policy is formulated, especially when the views of many groups might be considered as part of the political process.

Impact/Effect lag
Is the time it takes for the policy to have an impact on the level of economic activity.

Question 33

Distinguish between inside and outside lags. Which is the longest in relation to fiscal policy?

Answer 33

Inside lags- the analysis of data and decisions as to appropriate action within the government.
Outside lags- the time taken for the policy to take effect.

With fiscal policy, the inside lag is long because the budget is only handed down once per year. The outside lag is comparatively short because of the potential direct impact of the budget announcements on the economy.

Question 34

Explain why fiscal policy is regarded as fairly inflexible.

Answer 34

Fiscal policy is regarded as relatively inflexible. In developing the budget, Treasury cannot really make large changes to the patterns of allocation and distribution established in past years. There are social and political constraints which impinge on the economic fabric of the budget.

Question 35

To what extent is fiscal policy constrained by political cycles?

Answer 35

Political constraints impact on the budgetary process, because governments seek re-election. There appears to be a political business cycle- in the first year of its term, the government will apply tough fiscal measures, but in the year preceding the election, budgetary measures may appear easier- perhaps to ‘buy’ votes from the electors.

Question 36

Explain why budgetary process can have an unintended impact on private sector businesses.

Answer 36

The ‘crowding out’ hypothesis suggests that a budget deficit can actually make it harder for the private sector to participate in recovery because the supply and cost of loanable funds becomes tighter. This could have a negative effect on firms funds in the private sector because the availability of loanable money falls, and its price (the interest rate) is higher.
Hence, business borrowing becomes a more risky proposition, and private firms may decide not to go ahead with plans to borrow.
At the extreme, crowding out could become a ‘zero sum game’- increased government expenditure would be cancelled out by reduced private sector activity. In that case, expansionary fiscal policy would have no effect on the economy.

Question 37

Provide an example of where fiscal policy was at odds with other policy settings (do the current policy settings also represent this situation?)

*need to know

Answer 37

Fiscal policy should be part of the overall policy picture- it should not conflict with the direction taken by monetary policy.

The Australian government cut taxes for five years in a row between 2003 and 2007, despite a BOOMING economy (with nine increases in the official interest rates over the same period).
Fiscal and monetary policy stances seemed at odds over this period, although this can be explained by the government’s use of its budgeting powers to return some of the surplus to taxpayers and to focus on long term structural reforms to the economy.

Question 38

Until the GFC, fiscal policy had not been regarded as a demand management tool- rather the focus was on longer term structural change.
Explain the main problem in the Australian economy which meant fiscal policy was seen in this way.

Answer 38

• In recent years, Treasurers from both political parties have tended to apply fiscal policy outside of Keynesian principles. Instead, they emphasized long term structural balance.
• A number of factors explain this change in approach. Firstly, unemployment for most of the last 20 years has remained stubbornly above 5 per cent of the workforce.
• At face value, it would seem that expansionary fiscal policy would work well in this situation. In fact, it does not, because 5 per cent unemployment is now regarded as full employment (the natural rate).
• The Australian economy had close to zero cyclical unemployment for most of the 2000’s. The fact that there were still high levels of unemployment could be attributed to structural causes- a mismatch between the supply and demand of job skills, or when the rate of structural change in the economy exceeds that rate at which the unemployment can be restrained and ‘up-skilled’.
• *Essentially, structural unemployment reflects supply-side problems in the economy that are difficult to solve using demand management policies like traditional fiscal policy.

Question 39

Explain the two structural problems in Australia’s economy that caused the focus of fiscal policy to be on long term structural change.

Answer 39

• Secondly, budgets have been in deficit even in times of reasonable growth.
• Traditional fiscal policy is cyclically balanced- deficits in recession, and surpluses in booms.
• If not, this suggests structural problems in the economy.
• In Australia’s case, there were two important structural problems in recent years: the CURRENT ACCOUT DEFICIT and the IMBALANCE BETWEEN SAVINGS AND IMVESTMENT.
• These problems caused a shift in government thinking for most of the 1990’s and 2000’s, and greater emphasis on getting the long term structure of the economy right.
• Governments have this paid much more attention to moving the budget outcome into long term surplus.

Question 40

What has been the preferred tool for demand management in recent years?

Answer 40

In recent years, monetary policy has been the preferred tool for demand management, as it has advantages over fiscal policy in some areas, especially its flexibility.
This does not mean to say that traditional budgetary policy no longer has a role. In fact, the stimulus packages used around the world since the onset of the GFC attest to its role in restoring aggregate demand.

Question 41

Explain the deficit debate- the relationship between economic growth and the budget outcome.

Answer 41

There is a relationship between economic growth and the budget outcome. Periods of weak economic growth mean the budget goes into deficit. Stronger growth raises revenue and reduces claims on government funds, so the Budget comes back into surplus.
In part, this is dues to automatic stabilisers, and in part, due to counter-cyclical fiscal policy.
*Note that there is usually a time lag between a change in economic activity and a change in the budget balance).

Question 42

What is the planned deficit for the 2018-19 budget?

Answer 42

The budget outcome for 2018-19 is expected to be a deficit of $14.6 billion (or equal to 0.8% of GDP).
This means that the government expects this year’s budget to be not as expansionary as last year’s.

Question 43

What are the projected outcomes for the next three budgets?

Answer 43

2019-20 -> $2.2 bn
2020-21 -> $10.9 bn
2021-22 -> $16.6 bn

Question 44

Explain the structural deficit- identifying the two main reasons for this.

Answer 44

Over the last 10 to 15 years, however, there have been a number of fundamental changes in the structure of the economy which mean improving economic conditions are less likely to bring the budget back to surplus.

The largest structural change is demographic- the aging population. In real terms, per capita expenditure on social security has risen by fifty per cent since the early 1990’s. Much of this increase was attributed to pension claims. Per capita spending on health has nearly doubled over the same period.

Other long-term changes in revenue and expenditure have resulted from the fall in ther terms of trade since 2010, and the end of the mining construction boom from about 2015.
These structural changes have hampered the ability of the government to raise revenue.

A combination of these events have put Australia on path to a structural deficit- revenue is now 23% of GDP, whilst spending is 26%. Some of the difference between revenue and expenditure is still due to lower-then-normal economic growth, but a goods proportion of it is the result of the structural deficit.

Question 45

Describe five major initiatives announced in the 2018-19 Budget.

Answer 45

• Cuts to personal income tax rates via a sever-year tax plan. This will, in the short run, provide lower tax rates for low and middle income earners.
• Implementation of a $75 billion 10-year national infrastructure plan.
• Improving water infrastructure.
• Investing more than $500 million to secure the future of the Great Barrier Reef.
• A new public hospital agreement will deliver more than $30 billion in additional funding between 2020-2025.

Question 46

Why has there been considerable debate about government debt over the last five years?

Answer 46

The accumulation of debt is a concern for the government. If deficit budgets are allowed to continue, more money needs to be borrowed by the government to finance these deficits. As a result, more government outlays will be needed to pay interest on debt. This will mean that less will be available to finance other national needs.

Over the last five years, there as been considerable debate about the government debt. On one hand, Australian government debt appears low by comparison with similar economies, in which case we may be able to afford to build debt and pay if off later. On the other hand, the structural headwinds are likely to continue to bring low revenue growth.