Reading 14: Fiscal Policy

Book 1 Economics

Fiscal Policy

the government’s use of spending and taxation to influence economic activity

What are the three fiscal policy objectives?

1.) Influence economic activity and aggregate demand

2.) Redistribute welath and income amongst the population

3.) Allocating resources among economic agents and sectors

What does Keynesian economics say about fiscal policy?

It works when the economy is not at full employment

Discretionary Fiscal Policy

spending and taxing decisions of a national government that are intended to stabilize the economy

Automatic Stabilizers

built-in fiscal devices triggered by the state of the economy

What are the arguments for being concerned about the fiscal deficit?

1.) Higher deficits lead to higher future tax rates. This disincentivizes individuals to work, thus lower productivity and halting economic progress

2.) If the market loses confidence in the government to pay back debt, lenders won’t refi. This will lead to either a.) the government defaulting on its debt or b.) hyperinflation as more and more money is printed

3.) Increased government borrowing will increase interest rates. Private investment will cut down on credit use and eventually stop investing. The Crowding Out Effect

What are the arguments against being concerned about the fiscal deficit?

1.) If the debt is held by consumers, the scale of the problem is overstated

2.) If the debt is used to finance productive capital returns, future gains will be able to repay the debt

3.) Fiscal deficits may prompt needed tax reform

4.) Ricardian Equivalence – people are smart and recognize there will be higher taxes needed in the future and save a greater portion of their income

5.) If the economy is operating at less than full capacity, there is enough human capital to handle injected demand and not drive inflation up

Categories of Fiscal Policy Tools

Spending Tools

Revenue Tools

Spending Tools

Redistributing Wealth – SS, unemployment benefits

Current Spending – government purchases of goods and services

Capital Spending – government purchases of infrastructure

When are spending tools most effective?

when trying to increase aggregate demand

Revenue Tools

Direct Taxes – taxes on income

Indirect Taxes – taxes on goods and services

Horizontal Equality

taxes are fair because people in similar situations should pay similar taxes

Vertical Equality

taxes are fair because rich people get taxed more than poor people

Advantages of fiscal policy tools

Social policies can be implemented via indirect taxes

Implementation of indirect taxes is quick

Disadvantages of fiscal policy tools

Direct taxes and transfer payments take time to implement

Capital spending takes a long time to implement

Marginal Propensity to Consume (MPC)

those who have a smaller income spend more of their income on consumption that people who have large incomes

Fiscal Multiplier Effect

When the government injects money via expansionary fiscal policy, it increases consumer spending (group 1). This group then spends money into other businesses which then increases consumers (group 2) ability to spend. This is a finite domino effect

Disposable Income

After-tax income

Types of Lag that Impact Fiscal Policy

Recognition Lag – takes awhile for policymakers to see there’s a problem

Action Lag – takes awhile for policymakers to implement policy

Impact Lag – takes awhile for policy to actually work

Additional Macro Issues that Hinder Fiscal Policy

Supply shortages – if resources are constrained, fiscal policy won’t work, higher inflation

Limits to Deficits – Expansionary policy won’t work if consumers think the deficit is too high

Multiple Targets – high unemployment + high inflation means fiscal policy won’t work