4.5.3 Public Sector Finances

Distinction between automatic stabilisers & discretionary fiscal policy

• Automatic stabilisers = changes to government spending & taxation due to the economic cycle (automatic), independent of government plans

  • In recession: unemployment increases → government spending on unemployment benefits increases (government spending is automatic)

  • In recession: unemployment increases → less income → income tax decreases → tax revenue decreases (can tax less from income tax)

  • Therefore, these stabilisers help somewhat boost AD (from automatic increased government spending) in recession

  • In a boom, the above will be opposite so help reduce AD & inflationary pressures

• Discretionary fiscal policy = deliberate, planned changes in government spending & taxation by the government to incluence the level of economic activity

Distinction between a fiscal deficit & the national debt

• Fiscal deficit (budget deficit) =. Situation where government spending exceeds tax revenue in a year

  • Start at 0 for every country every April

• National debt = total money still owed by a country’s government + all unpaid borrowing from the past

Distinction between structural & cyclical deficits

• Structural deficit = government debt due to long-term economic problems

  • The need for borrowing/spending may not disappear unless the issues can be solved

  • These issues may be: ie. An increase in healthcare spending due to an ageing population

• Cyclical deficit = government debt due to a recession

  • The need for borrowing/spending will disappear if the economy is able to reach a strong recovery - boom

  • These issues may be: ie. A fall in income tax revenue due to a sudden fall in economic growth

Factors influencing the size of fiscal deficits

• Stage of the economic cycle

  • In recession:

  • increase unemployment → increase government spending on unemployment benefit

• Tax revenue

  • In recession:

  • Decrease tax revenue as less income to tax

• Demographic changes (ie. Increase in aging population - increase in spending on them)

• Demand for public & merit goods

• Political priorities (ie. Spending on expanding social programs…)

• Unforeseen events

Factors influencing the size of national debts

1) Size of fiscal deficit - Add to debt (how much more debt is being added each year)

2) Size of government policies - reduce debt (how government prioritises paying off debt vs other spending)

• ie. Austerity policies: prioritise paying off debt by cut spending on public services / benefits

The significance of the size of fiscal deficits & national debts (Does it matter if these are large?)

The matterness depends on:

1) can a country meet the repayment schedule?

depends on

• past behaviour

• Current behaviour

If these behaviour were bad then it could lead to 2 outcomes:

• Markets demanding higher yields (higher interest rate) to lend money to a government

• Markets not lending money to government at all

Result: Even worse debt problems

Therefore, retaining market confidence about repayment is crucial so government can have enough money to repay debts

2) How large is the opportunity cost of having a large debt?

• Any money spent on debt repayment can’t be spent on other uses (ie. Edu)

• Therefore, government needs to ensure debt repayments stay small enough to have as little opportunity cost as possible

  • Paying debt back quickly now might be hard (higher opp cost - can cause economic problems now) but lowers opportunity cost in the future

  • However, the economic problems encountering now from paying debt back might have to be paid for later - may increase back the opportunity cost in future

Austerity policies (not in spec) (part of discretionary fiscal policy / government policies to reduce national debt)

• Austerity = a period of fiscal restriction in order to pay back previous borrowing quickly

• Therefore, can employ austerity policies (part of discretionary fiscal policy)

• Pro austerity:

  • By cut spending now can avoid another recession

  • Otherwise too much money will be wasted on interest payments

    • This has opportunity cost in other spending areas because too much money is spent on interest repayments

    • bond markets will become nervous as investors think the government is not responsible with debt repayments → demand higher interest rates to lend money

• Evaluation points for austerity (Anti-austerity):

  • Once we reach strong recovery / boom, growth will repay the borrowing(debt) anyway

  • Austerity will stop growth

    • cut government spending/increase tax → decrease AD → less growth