VCE Economics Unit 4 AOS1 - Budgetary Policy

Why are aggregate demand policies needed?

Used to stabilise the business cycle by influencing the level of spending in the economy. They aim to reduce the severity of economic fluctuations and help achieve the government's domestic macroeconomic goals of:

- Strong and sustainable economic growth

- Full employment

- Low inflation

What is the business cycle?

Refers to fluctuations in economic activity over time, measured by changes in real GDP. The stages are:

- Recovery

- Peak

- Slowdown/Recession

- Trough

Aggregate demand policies aim to smooth these fluctuations.

What is budgetary policy?

Refers to the Australian Government's manipulation of government revenue and expenditure through the federal budget to influence aggregate demand and achieve macroeconomic goals.

Sources of government revenue

1. Direct taxation

- Income tax

- Company tax

2. Indirect taxation

- GST

- Excise duties/taxes

3. Revenue from government businesses

4. Sale of government assets

What are direct taxes?

Taxes imposed directly on income or wealth.

Examples:

- Personal income tax

- Company tax

Direct taxes cannot be shifted to another party.

What are indirect taxes?

Taxes imposed on spending or production.

Examples:

- GST

- Fuel excise

Indirect taxes can be passed on to consumers through higher prices.

Types of government expenditure

1. Current expenditure (G1)

2. Capital expenditure (G2)

3. Transfer payments

Government current expenditure (G1)

Spending on day-to-day operations and services.

Examples:

- Public sector wages

- Healthcare

- Education

Government capital expenditure (G2)

Spending on productive assets that increase future productive capacity.

Examples:

- Roads

- Railways

- Schools

- Hospitals

Transfer payments

Payments made by the government without receiving a good or service in return.

Examples:

- JobSeeker

- Age Pension

- Youth Allowance

- Centrelink

Balanced budget

Government revenue equals government expenditure.

Revenue = Expenditure

Budget surplus

Government revenue exceeds government expenditure.

Revenue > Expenditure

Usually contractionary.

Budget deficit

Government expenditure exceeds government revenue.

Expenditure > Revenue

Usually expansionary.

Ways government can finance a deficit

1. Borrowing through government bonds

2. Selling government assets

3. Using previous surpluses

Ways government can utilise a surplus

1. Repay government debt

2. Invest in infrastructure

3. Build fiscal reserves

Relationship between budget outcomes and public debt

- Budget deficits generally increase public debt.

- Budget surpluses can reduce public debt.

- Public debt accumulates from past deficits.

What are automatic stabilisers?

Budget features that automatically influence aggregate demand without deliberate government action.

Examples:

- Progressive income tax

- Welfare payments

Automatic stabilisers during strong economic growth

- Higher incomes increase tax revenue.

- Welfare payments fall.

- AD is reduced.

- Inflationary pressure decreases.

Automatic stabilisers during an economic slowdown

- Tax revenue falls.

- Welfare payments rise.

- AD increases.

- Economic activity is supported.

Effect of automatic stabilisers on the budget outcome

During a downturn:

- Deficit becomes larger

During strong growth:

- Surplus becomes larger

What are discretionary stabilisers?

Deliberate government decisions to change spending or taxation to influence aggregate demand.

Expansionary budgetary policy

Government:

- Increases spending

- Reduces taxation

Result:

- AD increases

- Economic growth rises

- Employment rises

Contractionary budgetary policy

Government:

- Reduces spending

- Increases taxation

Result:

- AD decreases

- Inflationary pressure falls

Effect of expansionary budgetary policy on the budget outcome

Usually increases the budget deficit or reduces a surplus.

Effect of contractionary budgetary policy on the budget outcome

Usually reduces a deficit or increases a surplus.

How can expansionary budgetary policy promote strong and sustainable growth?

SSEG = economic growth that is strong enough to create jobs, yet not too strong that it inflicts external pressures (3-3.5% p.a.)

Higher government spending and lower taxes increase AD, leading to increased real GDP growth.

How can expansionary budgetary policy promote full employment?

FE (NAIRU) = the lowest rate of unemployment possible without placing excessive upwards pressure on inflation (4-4.5% p.a.)

Higher AD increases demand for labour, reducing cyclical unemployment.

How can contractionary budgetary policy help achieve low inflation?

LSI = a steady increase in the general price of goods and services (2-3% p.a.)

Lower AD reduces demand-pull inflationary pressures.

Strengths of budgetary policy

- Direct impact on AD

- Can target specific sectors

- Supports employment

- Improves infrastructure and productivity

Weaknesses of budgetary policy

- Political constraints

- Can increase public debt

- Risk of crowding out private investment

How can budgetary policy improve living standards?

- Higher incomes

- Greater employment

- Better access to services

- Improved material (access) and non-material living standards (wellbeing)

How can budgetary policy reduce living standards?

Poorly targeted policies may cause:

- High inflation

- Higher unemployment

- Increased public debt

- Lower purchasing power

Personal income tax cuts

- Increase disposable income

- Increase consumption

- Increase AD

- Support growth and employment

Personal income tax cuts (2026-27 Budget)

The tax rate on income between $18,201 and $45,000 was reduced from 16% to 15% from 1 July 2026.

Impact:

- Increases disposable income

- Increases consumption spending

- Increases aggregate demand (AD)

- Supports strong and sustainable economic growth and full employment

This is an expansionary discretionary stabiliser.

Working Australians Tax Offset (2026-27 Budget)

A tax offset reduces the amount of tax payable by eligible workers.

Impact:

- Reduces tax payable

- Increases disposable income

- Increases consumption spending

- Increases aggregate demand (AD)

- Supports economic growth and employment

This is an expansionary discretionary stabiliser.

Capital Gains Tax (CGT) Reform (2026-27 Budget)

The government will replace the 50% CGT discount with an inflation-indexed discount and introduce a minimum 30% tax on capital gains from 1 July 2027.

Impact:

- Increases government tax revenue

- Reduces after-tax returns from some investments

- May reduce investment spending and aggregate demand (AD)

- May help improve housing affordability by reducing speculative investor demand

- Supports low inflation and housing affordability objectives

This is generally considered a contractionary discretionary stabiliser because it increases taxation and can reduce AD.

Impact Lag

The time taken for a budgetary policy measure to affect aggregate demand and the wider economy.

Example: Tax cuts may take time before households increase spending.

Implementation Lag

The time taken for a budgetary policy measure to affect aggregate demand and the wider economy.

Example: Tax cuts may take time before households increase spending.

Budget stance

The budget stance refers to the direction and impact of government budgetary policy on aggregate demand (AD) in a given period.

Budget outcome

The budget outcome refers to the actual fiscal result of the government budget in a financial year.