chapter 7
Chapter 7: Fiscal Policy
Learning Objectives
Key Factors Affecting Federal Government’s Budget
The federal government’s budget depends on three major factors:
The rate of taxation: Influences the amount of revenue collected by the government.
The size of the GDP: Affects overall economic activity and the government’s revenue potential.
The government's own spending levels: Determines the overall government expenditure in the economy.
Budget Policy Aims
Full-Employment Equilibrium: Discusses the advantages and disadvantages of a budget policy aimed at achieving full employment.
Balanced Budget: Examines the pros and cons of implementing a balanced budget each fiscal year.
Both Full Employment and Balanced Budget: Analyzes the implications of a budget policy that achieves both objectives over the business cycle.
National Debt: Discusses the causes, size, and issues related to the national debt.
Fiscal Policy
Definition: Fiscal policy is the government's strategy regarding its own spending and taxation levels.
The Minister of Finance presents an annual budget to Parliament, which includes estimates for government revenues and expenditures for the upcoming year.
Federal Government’s Budget for Fiscal Year Ending March 2023
Revenues ($ billions)
Personal income taxes: 197.3
Corporate and other income taxes: 79.3
GST, excise, and energy taxes: 65.3
Employment Insurance (EI) premiums: 25.8
Other revenues: 40.7
Total Revenues: 408.4
Expenses ($ billions)
Transfers to persons: 125.1
Spending grants to other levels of government: 90.0
Direct program spending: 210.3
Public debt charges & actuarial losses: 35.8
Total Expenses: 461.2
Budget Status
Budget Deficit: 52.8 billion.
Distribution of Revenues and Expenses
Revenue Distribution:
Personal Income Tax: 48%
Corporate Income Tax: 19%
EI Premiums: 6%
GST and Other Revenues: 16% and 10% respectively.
Expense Distribution:
Direct Program Expenses: 46%
Transfers to Persons: 27%
Transfers to Other Levels of Government: 19%
Public Debt Charges: 8%
Key Definitions
Net Tax Revenue (NTR): The total tax revenue received by the government less transfer payments.
Formula: NTR = Total Tax Revenue - Transfer Payments
Budget Balance: The difference between net tax revenues and government spending.
Formula: (where G = government spending)
Budget Surplus: Occurs when net tax revenue exceeds government spending on goods and services.
Budget Deficit: Occurs when government spending on goods and services exceeds net tax revenues.
National Debt: The cumulative total of the federal government’s annual budget deficits minus any surpluses.
Balanced Budget: A budget where net tax revenues equal government spending on goods and services within a specified time frame (generally a year).
Understanding the Economy's Impact
At a real GDP of Y2, net tax revenues (NTR) and government spending (G) are equal, thereby achieving a balanced budget.
As GDP increases to Y3, higher tax revenues result in a budget surplus.
Changes Affecting Government Budget
Various factors impact the government budget, including:
Changes in the level of GDP.
Variations in tax rates.
Fluctuations in government spending levels.
Effects of Changes:
Increase in Government Spending:
It shifts the G line up and consequently lowers the budget line.
Increase in Taxes:
Shifts both the NTR line and the budget line upwards.
Philosophies of Fiscal Policy
Countercyclical Fiscal Policy:
When facing a recession, the government should increase spending, and during inflationary booms, it should decrease spending to stabilize the economy.
Balanced Budget Fiscal Policy:
Focuses on annual budget balance as the primary aim.
Cyclically Balanced Budget Policy:
A combination of the above two approaches, balancing the budget over multiple years rather than annually.
J.M. Keynes and the Aggregate Expenditure Model
Keynes introduced the Aggregate Expenditure model in response to the Great Depression:
Components of Aggregate Expenditure:
Where C = Consumption, I = Investment spending, G = Government Spending, Xn = Net Exports.
Keynes's belief was that the Depression was caused by decreased aggregate expenditures and that increasing demand via government spending would help recover the economy.
Counter-Cyclical Fiscal Policy Applications
Addressing Recessionary Gaps:
Raise government spending (G) and/or lower taxes (T) to increase total spending towards Aggregate Demand (AD2), shifting the economy back to full employment level (YFE).
Addressing Inflationary Gaps:
Lower government spending (G) and/or raise taxes (T) decreases total spending towards AD2, thereby controlling inflation.
Summary of Counter-Cyclical Fiscal Policy
Recessionary Gaps: Government actions should be focused on increasing aggregate demand.
Inflationary Gaps: Focus should shift toward decreasing aggregate demand.
Impacts of Fiscal Policy on Aggregate Demand Curve
When Taxes Increase: Shifts aggregate demand curve left.
When Government Spending Decreases: Shifts aggregate demand curve left.
Countercyclical Policy Closing Recessionary Gap: Shifts aggregate demand curve right.
Countercyclical Policy Closing Inflationary Gap: Shifts aggregate demand curve left.
Shortcomings of Counter-Cyclical Fiscal Policy
Subject to time lags: Delays in policy implementation can lead to ineffective outcomes.
Risk of crowding out effects: Private sector investment may decrease due to increased government borrowing.
Potential for budget deficits: Fiscal policies can exacerbate the national debt.
Balanced Budget Fiscal Policy
The government aims for a balanced budget each budget period, which has advantages:
Avoids issues linked to counter-cyclical policies and relies on automatic stabilizers (tax laws and spending programs).
Shortcomings of Balanced Budget Policy
In recessionary times, cutting government spending can lead to increased unemployment.
In boom times, increased government spending can worsen inflation.
Cyclically Balanced Budget Fiscal Policy
Concept involves balancing the budget over the business cycle, resulting in:
Running budget deficits to combat unemployment during recessionary periods.
Running budget surpluses to mitigate inflation during inflationary periods.
Definitions of Deficits
Structural Deficit: A deficit persisting even at full employment GDP levels.
Cyclical Deficit: Results specifically from recessionary conditions.
Defined as:
Problems with Cyclically Balanced Budgets
Lack of guarantee that the timing and scale of recessionary gaps will offset inflationary gaps.
Political challenges in reducing government spending during prosperous times.
Fiscal Policy and the National Debt
The government funds its operations typically through issuing bonds.
These bonds represent debt held by individuals, corporations, and financial institutions, leading to interest payments that redistribute wealth from taxpayers to wealthy bondholders.
National Debt Statistics**
Trends in national debt from 1926 to 2022, measured in 2012 dollars, indicating changes over time.
Effects of High Deficits/Debt
Burden of interest payments on foreign-held debt.
Redistribution effects of significant interest payments.
Restricted ability of the government to meet its citizen’s needs.
Concerns over potential for increased governmental wastefulness and power consolidation.
Invalid Criticisms of National Debt
Unlike private companies, a country cannot declare bankruptcy.
Future generations inherit both the debt and the bonds associated with it.
Emphasizing debt without considering an institution’s asset side is misleading.
Assessment of debt should consider its proportion to GDP (e.g., Canada’s current low percentage at 45%).
Conclusion | Summary
The federal government’s budget is contingent on the interactions of taxation rates, GDP size, and spending levels, with various fiscal policies comprising countercyclical, balanced budget and cyclically balanced budget approaches, each with their respective pros and cons. Furthermore, an understanding of the national debt's causes, dimensions, and associated problems is crucial in the broader fiscal policy discourse.