ECON 102 - Chapter 7

Fiscal Policy and the Budget

Prepared by Ifeanyi Uzoka, Sheridan College Principles of Macroeconomics: SAYRE, MORRIS, GHAYAD Eleventh Edition

Learning Objectives

• Describe why the federal government’s budget depends on three factors:

  • The rate of taxation

  • The size of the GDP

  • Its own spending levels

• Explain the pros and cons of a budget policy aimed at achieving full-employment equilibrium

• Explain the pros and cons of a budget policy aimed at achieving a balanced budget in each fiscal year

• Explain the pros and cons of a budget policy aimed at achieving both full employment and a balanced budget over the life of the business cycle

• Discuss the cause, size, and problems of the national debt

Introduction to Fiscal Policy

• Fiscal Policy: The government’s approach toward its own spending and taxation.

  • The Minister of Finance presents an annual budget to Parliament each spring.

  • The budget contains estimates of government revenues and expenditures for the forthcoming year.

Federal Government’s Budget for Fiscal Year Ending March 2023

Budget Overview ($ billions)

Revenues:

• Personal Income Taxes: 197.3

• Corporate and Other Income Taxes: 79.3

• GST, Excise, and Energy Taxes: 65.3

• EI Premiums: 25.8

• Other Revenues: 40.7

• Total Revenues: 408.4

Expenses:

• Transfers to Persons: 125.1

• Spending Grants to Other Levels of Government: 90

• Direct Program Spending: 210.3

• Public Debt Charges & Actuarial Losses: 35.8

• Total Expenses: 461.2

• Budget Deficit: 52.8

Revenue and Expense Distribution

Revenues:

• Personal Income Tax: 48%

• Corporate Income Tax: 19%

• GST: 16%

• Other Revenues: 10%

• EI Premiums: 6%

Expenses:

• Direct Program Expenses: 46%

• Transfers to Persons: 27%

• Public Debt Charges: 8%

• Transfers to Other Levels of Government: 19%

Key Terms in Fiscal Policy

• Net Tax Revenue (NTR): Total tax revenue received by the government less transfer payments.

  • Equation: $NTR = ext{tax revenue} - ext{transfer payments}$

• Budget Balance: The difference between net tax revenues and government spending.

  • Equation: $ext{Budget Balance} = NTR - G$

• Budget Surplus: Net tax revenue in excess of government spending on goods and services.

• Budget Deficit: Government spending on goods and services in excess of net tax revenues.

• National Debt: The sum of the federal government’s annual budget deficits minus its surpluses.

• Balanced Budget: The equality of net tax revenues and government spending on goods and services within a given time period (Year).

Historical Trends in Canada’s Budget

Revenues and Expenditures Over Time

• A graphical depiction shows budget revenues and expenditures from 1966 to 2022, indicating dynamic changes in fiscal policy and economic conditions.

Economic Influences on Government Budgets

• Determines of the government budget include:

  • Changes in GDP: Affects budget revenues and expenses.

  • Changes in Tax Rates: Directly influences overall tax revenues.

  • Changes in Government Spending (G): Shifts budget outcomes.

Effects of Government Spending and Taxes

• An increase in government spending shifts the G line up and shifts the budget line (BL) down.

• An increase in taxes graphically shifts both the NTR line and the budget line (BL) up.

Philosophies of Fiscal Policy

Distinct Approaches

1. Countercyclical Fiscal Policy:

   • When faced with a recession, the government should overspend; during inflationary periods, it should underspend.

   • Goals: Achieve full employment and maintain stable prices.

2. Balanced Budget Fiscal Policy:

   • Aiming to balance the budget annually is the primary fiscal goal.

3. Cyclically Balanced Budget Policy:

   • Combines the principles of both the earlier policies to balance the budget over the business cycle rather than annually.

Countercyclical Fiscal Policy

Key Concepts

• Developed by J.M. Keynes as a reaction to the Great Depression.

• Aggregate Expenditure Model:

  • Components:

  • $C$ = Consumption

  • $I$ = Investment Spending

  • $G$ = Government Spending

  • $Xn$ = Net Exports

  • Aggregate Expenditure Equation: $AE = C + I + G + Xn$

Keynesian Insights

• The Great Depression was attributed to a decrease in aggregate expenditures.

• To alleviate depression, Keynes advocated increasing aggregate demand through government expenditure.

  • Increases funded through borrowing, as other spending sources were limited.

Policy Applications

• Recessionary Gap Response:

  • Raise $G$ and/or lower $T$ to increase total spending and aggregate demand, shifting back to full employment.

• Inflationary Gap Response:

  • Lower $G$ and/or raise $T$ to decrease total spending, shifting back to full employment.

Challenges in Countercyclical Policies

Shortcomings

• Time Lags: Policies can be subject to delays in implementation and effect.

• Inflationary Bias: Tends to promote inflationary outcomes.

• Crowding Out Effect: Increased government spending might displace private sector investments.

• Budget Deficits: May lead to increased government borrowing and debt.

Balanced-Budget Fiscal Policy

Governance & Implications

• This policy aims to balance the budget in each fiscal cycle.

  • Advantages:

  • Avoids issues related to counter-cyclical policies.

  • Relies on automatic stabilizers, which adjust government spending in response to economic cycles.

Challenges of Balanced-Budget Policies

• In recessions, cutting government spending raises unemployment.

• In booms, increased government spending may exacerbate inflation.

• This policy can be procyclical, worsening existing economic conditions.

Cyclically Balanced Budget Fiscal Policy

Approach Overview

• This approach aims for a balanced budget across the entire business cycle rather than annually.

  • Deficit Management: Running deficits to mitigate unemployment during recessionary periods.

  • Surplus Strategy: Accumulating surpluses to counter inflationary pressures during economic expansions.

Political and Economic Limitations

• Political Challenges: Easing government spending during positive economic times is politically challenging.

• Timing Issues: The political cycle seldom aligns with the business cycle, complicating fiscal management.

Fiscal Policy and the National Debt

Government Borrowing Practices

• The government borrows funds primarily through issuing bonds, which are held by various entities such as individuals and institutions.

• Income Redistribution Effects: Interest payments on the borrowed funds primarily benefit wealthy bondholders, redistributing wealth among taxpayers.

National Debt Trends

• Overview of National Debt from 1926 to 2022 in inflation-adjusted dollars and its implications on economic policy.

Implications of High National Debt

• Interest Payments: High foreign-held debt requires consistent interest payments.

• Citizen Needs: Limited ability to satisfy public service demands due to high debt costs.

• Governance Issues: Potential for government wastefulness and power consolidation due to budget constraints.

Invalid Criticisms of National Debt

• Persistent Revenue Generation: Unlike private firms, nations cannot go bankrupt; future generations inherit both debt and assets linked to it.

• Assets Consideration: Concentrating solely on debt without considering associated assets provides a skewed perspective.

• Debt-to-GDP Context: Evaluating the debt in relation to GDP is more effective; Canada’s debt-to-GDP ratio remains relatively low (approximately 45% historically).

Chapter Summary

• Federal government’s budget is shaped by taxation rates, GDP size, and expenditure levels.

• Pros and cons are discussed regarding counter-cyclical and balanced budget policies, along with the cyclically balanced approach.

• Comprehensive analysis of the national debt, its causes, implications, and trends is presented.