Fiscal Policy

Note: Outcome vs stance -> outcome already happened (Actual budget), stance is what the are hoping to achieve (Planned budget)

Always address the downside that the government is addressing

Every individual, household, business firm or organisation has a budget in which it identifies its sources of income and the ways in which those funds will be spent over a period of time.

The federal Budget, usually delivered in Parliament in May each year, estimates government revenue and spending (expenditure) plans for the coming year.

The Commonwealth budget has a three functions.

• Firstly, it decides how revenue will be raised and allocates funds to areas of need.
  • Budget allocations don’t really change much from year to year because they are often determined by the funding needs of the public sector.
  • For example, education spending can’t be cut by 20 percent one year then raised by 20 percent the next, because it is an essential public service that provides for the needs of school – age children
• Secondly, the budget plays a role in income redistribution.
  • Wealthy households pay higher rates of tax, and those on lower incomes receive more government support (both direct and indirect) than those on high incomes.
• Thirdly, the government can use the budget to influence the level of macroeconomic activity (i.e to stabilise fluctuations in the business cycle).
  • In Australia, the first time a budget was deliberately used for this purpose was in 1951-52, when the budget was designed to cool the booming post war economy – inflation was above 15 percent and unemployment less than one per cent of the work force.

The ‘outcome’ of the budget refers to - the relationship between government revenue and government spending.

• There are 3 possible outcomes:
  • A balanced budget - revenue and expenditure are equal (G = T)
  • A surplus budget - revenue is greater than spending (T > G)
  • A deficit budget - spending exceeds revenue (G > T)

A surplus budget will occur when GDP growth is strong and the economy is close to full employment.

A deficit budget will occur in the opposite scenario when GDP growth is relatively slow or when the economy has contracted

It is almost certain that the actual budget result at the end of the year will differ from the planned outcome, for a number of reasons.

• Should there be a downturn in economic activity, business conditions would be tougher and taxation revenue from households and businesses would fall - actual deficit would be worse than the planned deficit
• On the other hand, an unanticipated upswing after the announcement of the budget would result in rising government revenues and lower welfare spending, in which case the actual outcome would be a smaller deficit than the forecast outcome.

Changes in conditions in world markets could impact on the budget outcome.

• Higher costs (such as rising oil prices) would put pressure on the budget because they signal higher transport charges.
• A fall in commodity prices (perhaps a fall in iron ore prices) would have significant impact on tax revenue.

Exogenous factors (external shocks) could also cause the actual outcome to differ from the predicted result.

• This has been evident in recent years with bushfires and floods in the eastern states, the coronavirus pandemic; and the Ukraine War.
• These events could not have been anticipated in the budget forecasts for the relevant years.

When the government records a budget deficit (spending is greater than income) then the difference needs to be financed – usually this is through government borrowing.

A budget surplus will mean that the government is now saving and can use the surplus funds to retire past debt or saved for the future.

• A budget deficit will have an expansionary effect on the economy because there is a net injection of funds into the economy.

Ways of Financing a Budget Deficit

There are 4 main ways in which a government can finance a budget deficit:

1. Selling new government bonds to domestic and/or overseas residents.
2. Borrowing from the central bank
3. Borrowing from overseas; and
4. Selling government assets

#1 Selling new government bonds

• Known as Commonwealth Government Securities (CGS). This method normally accounts for around 95 per cent of the government borrowing requirement.
• A bond is a financial instrument which raises funds for its issuer (in this case, the government), in return for a rate of interest payable to the buyer.
• They are guaranteed by the government and are very popular with institutional and private investors.
• They can be bought by both domestic and foreign residents.
• In 2022, of the 892 billion dollars worth of CGS on issue, 45 percent were owned by overseas residents.
• If you use surplus cash to buy a 1000 dollar government bond, on which the rate of interest is 2 per cent p.a. you are effectively lending money to the government in return for an annual interest payment of 20 dollars
• When the government issues new bonds it is competing for funds in the financial market.
• This can lead to interest rates rising which can discourage private borrowing - government borrowing creates higher demand for funds in the financial market.
  • Economists call this ‘crowding out’ – the private investment spending is said to be ‘crowded out’ by the higher government spending.
  • But selling bonds to domestic residents has the advantage that it does not affect the money supply – the public withdraws money from the banking system to pay for purchases of securities.
  • When the government spends the borrowed funds, the net effect on the money supply is nil.

#2 Borrowing from Central Bank

• A second method of financing the deficit is to borrow from the central bank (RBA) - This is referred to as ‘printing money’. uh ohhhhhh
• While this will have the desired expansionary effect on the economy, it could lead to higher inflation rates because it is directly increasing the money supply
• The Reserve Bank has recently stated that it will not finance the current government’s deficit.

#3 Borrowing from Overseas

• Thirdly, the government could borrow from overseas to fund a deficit, but this is rarely used.
• It would mean the government would seek loans from foreign banks or governments rather than issuing new government securities.
• If the government used this method it would directly add to the government’s foreign debt and result in an appreciation of the Australian dollar due to the inflow of money capital.
• An appreciation would counter the expansionary objective of the planned budget deficit by reducing exports - exchange rate appreciation makes exports less competitive, and imports more competitive against domestic goods.
• This would be counter to the objectives of the planned budget deficit.

#4 Selling government Assets

• The final method the government could use is to sell government (public assets).
• It can do this by privatising government business enterprises or by selling government property such as public land and/or building.
• While this method can raise finance, it is not used often because it can compromise the level of public services delivered in some situations.

What impact does a surplus have on public finances?

• The surplus could be used to retire (pay off) government debt built up by past deficits,
• held over to fund future expenditure,
• or returned to taxpayers (perhaps as a direct payment, perhaps as a tax cut).

Stabilising the Economy

Government economic policy is countercyclical – its objective is to ‘smooth’ the ups and downs of the business cycle.

Fiscal policy has an important role to play in meeting this objective

• We need to understand that there are automatic mechanisms that play a role in smoothing the fluctuations associated with the cycle.
• Even if the government makes no decisions about changing revenue or spending patterns, the budget balance will vary over the course of the business cycle due to automatic stabilisers.

When the economy is in the contraction phase of the cycle (slower growth), tax revenue falls and welfare payments rise so the budget balance moves towards a deficit.

When the economy is stronger (expansion phase), tax revenue rises and welfare payments fall; so the budget moves into surplus.

Income taxes and transfer payments act like an economic shock absorber.

• They limit the rise of aggregate spending in a boom, and increase it in a trough.
• Essentially, the taxation and transfer payments stabilisers mean the budget deficit will automatically increase as the economy contracts, and automatically decrease as the economy expands.
• Automatic stabilisers do not prevent fluctuations in the business cycle and are not by themselves sufficient to completely counteract the peaks and troughs in economic activity.

Discretionary Fiscal Policy

Discretionary fiscal policy refers to the deliberate changes to expenditure and revenue that the government makes in the budget to stabilise the economy.

Possible Fiscal Stances

• Expansionary policy, (Revealed by a budget deficit)
• Contractionary policy, (Revealed by budget surplus) and
• Balanced budget.

Expansionary Policy

An expansionary policy stance is usually associated with a deficit budget – where planned expenditure is higher than revenue.

Policy measures to stimulate household and business spending include:

• Reducing income tax to increase household purchasing power;
• Cutting corporate tax to stimulate business spending on inputs, employment and investment; (I)
• Increasing government spending on infrastructure, such as transport and communications projects. (G)
• Direct payments to households and/or firms

You can reduce an expansionary stance.

Both AE and ADAS models can be used to model the operation of expansionary fiscal policy and its effect on the level of output.

Modelling with AE

Modelling with ADAS

When economic output is below potential, increased aggregate demand will tend to soak up excess capacity and unemployed resources before putting much upward pressure on the price level

Contractionary Policy

In a period of stronger economic activity, it would be appropriate for the government to plan a budget surplus to reduce levels of spending in the economy.

• Policy options to achieve this contractionary outcome might include:
  • Increasing personal income tax rates and company taxes;
  • Reducing or postponing spending on major projects; and /or
  • Increasing excise taxes such as those applied on sales of cars, tobacco and alcoho
• It could be current or capital expenditure and might be taken from defence, education, health or infrastructure.
• The actual way in which revenue is increased or expenditure is cut is usually influenced by political as well as economic judgements.
• It is very difficult to make large cuts in government expenditure because most of the expenditure in any department (approximately 70 percent) is spent on wages and salaries.
• The size and scope of the public sector creates its own inertia which make budget cuts hard to design and implement.
  • Reductions tends to be made in small amounts over a period of time – pruning rather slashing.

    Modelling with AE

Modelling with ADAS

Budget Balance and Stance

The budget balance is determined by two factors

• Discretionary changes made by the government and (Structural)
• Automatic changes in response to the business cycle (Cyclical)

Budget balance = structural balance + cyclical balance

Fiscal Policy: Strengths & Weaknesses

Strengths:

• Fiscal policy is fairly direct (Other policies are not so direct but EXPLAIN why direct is good… not lagging so less time blah blah)
• Revenue and spending measures announced in the Budget can be implemented immediately, if required.
  • For example, the Treasurer might announce an increase in the excise tax on a commodity from the day after the Budget, or a reduction in the marginal rates of taxation after a certain date.
• Consumers feel the impact of these decision as soon as they come into law.
• Fiscal policy can be targeted to impact on specific sectors of the economy, and can also affect aggregate supply by, for example spending on infrastructure projects. (In theory all curves move but the most important is the AD curve)
• Keynesian economist believe that a strength of fiscal policy is its effects on the economy in recession – the government can open a ‘spending tap’ to increase the level of aggregate demand in the community.
  • e.g. GFC and covid
• Finally, well-timed fiscal policy measures and automatic stabilisers are complementary.
  • In a boom, both discretionary and automatic stabilisers dampen spending and economic activity.
  • In a downturn, discretionary and automatic stabilisers act together to stimulate spending and economic activity.

Weaknesses:

• Time lags
  • As with all economic policy, time lags may have an impact (as discussed in chapter 11).
    • The recognition lag occurs because economic indicators often lag the real trends, so policy making is based on out-of-date data.
    • The decision lag refers to the time that passes whilst appropriate policy is formulated, especially when different views might need to be considered as part of the political process.
    • The impact or effect lag is the time it takes for the policy to have an impact on the level of economic activity.
      • For fiscal policy, the impact lag is very miniscule, usually it takes a few days to be implemented
• Relatively inflexibility
  • In developing the budget, the Treasury cannot really make large changes to patterns of allocation and distribution established in past years
  • There are social, demographic and political constraints which impinge on the economic fabric of the budget – these cannot be ignored just to get the economy into shape.
  • It would be impossible, for example to reduce spending in a boom by cutting all defence spending or slashing social security payments.
  • Similarly, it is unlikely that social security benefits could ever be increased by more than a small amount at a time because funding larger benefits would be hugely expensive and may even encourage people to stop work.
  • Policy makers also have to consider possible costs of compliance due to policy changes - retailers, for example, would not react well to constant changes in excise tax rates on goods they sell
• Political machinations (Not an economic problem but can have an economic impact)
  • These impact on the budgetary process, because governments seek re-election.
  • In the first year of their term, governments tend to apply tough fiscal measures, but in the year preceding an election, budgetary measures may appear easier – perhaps to ‘buy’ votes from the electors.
  • In May 2022, for example, the Treasurer delivered an expansionary Budget prior to an election.
  • In October, the new government announced a Budget that limited expenditure growth in order to bring down the deficit.
• Unintended Impact
  • An important effect of the budgetary process is its unintended impact on decisions taken in the private sector.
  • 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 negative effects on firms in the private sector because the availability of loanable money falls and its price (the interest rate) rises.
  • Hence business borrowing becomes a more risky proposition and private firms may decide not to go ahead with plans to borrow.

***Note that whilst the focus of fiscal policy is often on shifting aggregate demand by changing governments spending and taxation, fiscal policy can also affect the aggregate supply curve through

• Spending on infrastructure, which adds to the capital stock. And
• The impact of income tax rates on the willingness of people to work (labour supply).