Fiscal Policy and Economic Stabilization

Stabilization Policies

Stabilization policies: Government intervention using fiscal and monetary policies to stabilize the economy.
Fiscal policy: Government's use of taxation, spending, and borrowing to stabilize the economy.
Expansionary fiscal policy: Government policy to increase aggregate demand through tax cuts, increased spending, or both.

Keynesian Economics

Keynes's theories are still influential and used during economic downturns.
The application of Keynesian-style stabilization policies during the 2008-2009 recession in the U.S. and Canada helped limit its severity and length.
Keynes explained the Great Depression by examining relationships among demand and income.
During the Great Depression, businesses reduced investment and laid off employees, decreasing income and consumption.
High tariffs halted trade as countries tried to protect their economies.
Governments decreased spending and raised taxes to balance budgets, shrinking the circular flow of income.
Classical economists advocated for minimal government involvement, believing it hindered resource allocation.
They believed prices, wages, and interest rates would eventually adjust to pull the economy out of the recession.
However, prices, wages, and interest rates did not adjust, and unemployment remained high.
Keynes argued that government policy could influence leakages and injections and manage aggregate demand when traditional market mechanisms fail.

Expansionary Fiscal Policy

Fiscal policy involves the government using its powers of expenditure, taxation, and borrowing to stabilize the economy.
During a recession, aggregate demand is too low, unemployment is high, and output growth is low or negative.
Expansionary fiscal policy increases aggregate demand by decreasing taxes, increasing government spending, or both to stimulate economic growth and lower unemployment rates.
Cutting taxes increases disposable income, increasing aggregate demand through consumption (C) in the GDP equation.
GDP = C + I + G + (X-M)
Increase in aggregate demand increases employment and GDP, moving the equilibrium closer to full-employment (FE) output.
There would be little increase in the general level of prices if the equilibrium remained below full-employment equilibrium.
Increasing government spending directly shifts the AD curve to the right through the government (G) portion of the GDP equation.
A reduction in the level of taxes encourages consumers to follow through by spending their increase in income on domestic production, as opposed to saving it or spending on imports.
If consumers do not increase consumption, aggregate demand will not increase.
Increasing government spending acts directly on aggregate demand, ensuring some effect.
To maximize the effect of expansionary fiscal policy, the government would both cut taxes and increase spending to stimulate aggregate demand.

Contractionary Fiscal Policy

When the economy suffers from inflation, aggregate demand is too high, employment is high, and there is high output growth.
Contractionary fiscal policy decreases aggregate demand by increasing taxes, decreasing government spending, or both to reduce upward pressure on prices.
Increasing taxes decreases disposable income, decreasing aggregate demand through the consumption (C) portion of the GDP equation.
The decrease in aggregate demand leads to a decrease in the inflation rate.
However, there is a trade-off of lowering GDP and employment levels as equilibrium moves back toward full-employment (FE) output.
Reducing government spending would reduce aggregate demand.
Using both tax and government-spending tools would increase the overall effect.
Contractionary fiscal policy: Government policies to decrease aggregate demand through tax increases and/or decreased spending.

Fiscal Policy and the Business Cycle

Fiscal stabilization policies aim to smooth out the ups and downs of the business cycle.

Automatic Stabilizers

Automatic stabilizers: Mechanisms built into the economy that help stabilize it by automatically increasing or decreasing aggregate demand.
Examples include Employment Insurance, welfare programs, and progressive taxes.
They act on aggregate demand before a recession or inflationary trend fully takes hold and require no direct action or legislation by policy-makers.
During economic downturns, EI payments increase as more people become unemployed, maintaining people's incomes and the consumption (C) portion of GDP.
Social assistance programs ensure people have a level of income to survive, increasing consumption and cushioning downward pressure on aggregate demand.
Payments from automatic stabilizers slow the leftward shift of the AD curve or begin to increase the rightward shift.
Progressive tax: A tax (such as income tax) in which the tax rate increases as an individual's income increases.
A progressive tax acts as a stabilizer as the percentage of income taken in taxes rises as incomes rise, increasing a leakage as incomes grow.
As a person's income rises and they move to a "higher tax bracket," the rate may rise from, for example, 20% to 30%.
This slows down the growth in consumption, stopping the AD curve from shifting too quickly to the right, which could lead to inflation.
Any built-in mechanism that increases or decreases government spending or taxation as the business cycle fluctuates is considered an automatic stabilizer.
The government may decide to change the level of EI payments or taxation levels, which are considered discretionary fiscal measures.

Discretionary Policy

Discretionary fiscal policy: Deliberate government action taken to stabilize the economy in the form of taxation or spending policies.
This is often contrasted with automatic stabilizers.

Changes in Spending

To stimulate the economy, the government can increase general spending in areas like health and welfare, culture, and education.
However, it is tough to decrease these budgets once the economy turns around.
Another way to increase spending is to undertake infrastructure programs, such as building roads, hospitals, schools, transit systems, and communications systems.
Infrastructure: The foundation of goods and services that allows an economy to operate efficiently.
Increased spending on infrastructure can be temporary and adds to the stock of an economy's capital goods, promoting the outward shift of the production possibilities curve in the future.

Changes in Taxation

To restrain or stimulate economic activity, the government can use discretionary fiscal policy to change the amount of tax it collects.
The government could raise or lower personal income taxes, corporate income taxes, or sales taxes, changing the amount of money leaking out of the circular flow of income during economic transactions.
The government can alter tax deductions or tax credits, such as RRSP contributions, child care expenses, payments of union dues, EI premiums, and education expenses.
Changing what is considered a deduction or credit would alter the amount of leakages in the circular flow of income.
The government may provide special tax incentives for business investment, such as larger capital cost allowances on new buildings and equipment, influencing aggregate demand through the investment (I) portion of the GDP equation.

Challenges of Using Fiscal Policy

While the application of fiscal policy as an economic tool has existed since the Second World War, its use is still controversial.

Government Budgets

Governments announce changes in revenue and spending plans in the spring by outlining the coming year's budget.
Government budgets are complex documents drafted for political and economic purposes, containing economic forecasts, macroeconomic goals, and social policy objectives.
A government can end up with one of three scenarios:
- Deficit budget: The government spends more than it collects in tax revenue and must borrow money to cover the shortfall.
- Surplus budget: The government collects more in tax revenue than it spends and has money left over.
- Balanced budget: The government spends an amount equal to what it collects in tax revenue.
Debt: The total amount that a government owes on money it has borrowed to fund budget deficits.
For example, if a government spends 150 billion but takes in only 130 billion, it has a deficit of 20 billion and must borrow that amount. If in the next year it spends 150 billion and takes in 140 billion, it has a deficit of 10 billion and an accumulated debt of 30 billion.

Views About Government Budgets

Economists have been divided on how fiscal policy should be used, when the government should have deficit, surplus, and balanced budgets, and why these decisions should be made.
Part of the issue lies in the difficulty of predicting the actual output gap.
Recessions are hard to predict, so little general agreement exists on when fiscal policy is needed, how much to apply, when it should be applied, and when it should be removed.
Expansionary and contractionary parts of business cycles are driven, in part, by irrational behavior by consumers and investors, which is very hard to predict.

Annually Balanced Budget

Until the Second World War, the primary aim of fiscal policy was to balance the budget annually.
During the Great Depression, the problem with a strict annually balanced budget policy became obvious as it could exacerbate an existing problem in the economy.
If the government seeks to balance the budget during recessionary periods, it must either cut back spending or increase taxes.
Both policies serve to intensify the effects of the recession by holding back aggregate demand.
By cutting back spending, the government spending (G) portion of GDP is reduced. By increasing taxes, the government reduces incomes due to increased tax leakages, which would reduce the consumption (C) portion of GDP.
During inflationary periods, tax revenues rise, and the government is forced to increase spending or lower the tax rate to balance the budget.
Either way, more income is put back into the circular flow of income, causing upward pressure on aggregate demand and subsequently causing further inflation.

Cyclically Balanced Budget

Classical economists believed that the economy was self-correcting, but Keynesian economists argued that governments should use their fiscal policy to achieve a high, stable level of national income with neither unemployment nor inflation.
During a recessionary phase, the government should run deficits by increasing government spending, decreasing taxes, or both.
During an inflationary phase, the government should run surpluses by decreasing government spending, increasing taxes, or both.
During weak economic times, the government should work to stimulate the economy; during expansionary and peak periods of economic activity, the government should work to slow the economy.
Over the whole cycle, the deficits and surpluses should balance, with the government acting as a stabilizer.

Deficit and Surplus Budgets as Necessary

The goal of having a cyclically balanced fiscal policy was criticized for not recognizing that the economy can sink into long periods of economic recession, while subsequent expansionary phases may be relatively short.
As a result, the budget may not be able to be balanced over the business cycle.
An extension of Keynesian theory held that fiscal budgets could be managed from the perspective of running deficits or surpluses when necessary.
A deficit budget would be used only when the economy needed a boost.
The general health of the economy was more important than the balancing of budgets over the business cycle.

Full-Employment Budget

Governments should achieve a non-inflationary, full-employment level of output and intervene with fiscal policy only when the economy falls below its full-employment targets.
Inflation control because of economic expansion should be left to the Bank of Canada through tools of monetary policy.
Full employment in Canada is generally considered to be achieved when the unemployment rate is in the range of 6 to 7 percent.
A full-employment budget would entail using just the right amount of government spending and taxation, combined with the multiplier effect, to shift the AD curve so that it intersects the AS curve at full-employment equilibrium.

Supply-Side Economics

Keynesian views on fiscal policy are not universal, and supply-side economics argues that government policies should encourage the growth of aggregate supply.
Increased private investment will lead to an increase in aggregate supply, and incentives such as tax cuts should be used to encourage savings and investment for this purpose.
They also believe that aggregate demand will take care of itself, as more people become employed through the increase in aggregate supply.
Critics of supply-side economics call it "trickle-down economics" and believe that tax cuts generally focus on helping corporations and those who are wealthy.
They argue that the benefits proposed by "supply siders" are supposed to eventually "trickle down" to everyone else but may be held on to by the wealthy and treated as a form of additional income.
Investment will only occur if businesses believe the economy will be robust enough to make investment worthwhile, which is unlikely in a downturn.
Increased savings also further reduces consumption, which means that investment is less likely. This scenario has been called the "paradox of thrift."
While savings may be good for an individual in an economy, if everyone saves too much and consumes less, aggregate demand falls, unemployment increases, incomes fall, and everyone has less opportunity to save.

Size of the Government Debt

The size of the government debt can limit the use of fiscal policy as an effective tool.
The higher the government debt, the higher the amount of government spending that must be devoted to servicing the debt.
If an expansionary fiscal policy is required due to economic conditions, the government would have little room to increase spending and cut taxes without further additions to the debt.
Many economists believe that the size of the debt itself is not as important as its size relative to the GDP.
In Canada, the net federal debt-to-GDP ratio peaked at 66.8 percent in 1995.
The economic downturn of 2008-2009 saw the government implement another deficit budget.

Cyclical vs Structural Deficit

Budget deficits have two components: a cyclical deficit and a structural deficit.
Cyclical deficit: The part of a deficit that is incurred when the government is trying to pull an economy out of a recession.
It would include spending on infrastructure projects and programs that invest in human capital, such as job retraining or the upgrading of skills.
The cyclical deficit would be just enough to put the economy at full-employment equilibrium.
Structural deficit: The deficit that would exist even if the economy were at full employment due to the structure of government spending and taxation policies and not current economic conditions.
Many economists consider the presence of a structural deficit to be a sign of financial mismanagement and an unnecessary addition to government debt.

Time Lags

The time lags that exist in utilizing fiscal policy can be problematic.
Recognition lag: The time it takes for the government to recognize there is a problem in the economy.
Decision lag: The time required for the government to determine the most appropriate spending and taxation actions to implement the desired fiscal policy.
Implementation lag: The time required to implement an appropriate fiscal policy after making the decision to carry it out.
Impact lag: The time required for a fiscal policy to bring about a change in the economy.
The total time lag may amount to years.
This delay leads to the potential for an "overcorrection."
If an expansionary fiscal policy is enacted, but the market self-corrects, the fiscal policy could actually create an undesired inflationary period. Conversely, a contractionary fiscal policy could cause a recession.
The time lags are why it is important for a government to have good automatic stabilizers in place, as they help to minimize the challenges associated with these lags.
Because they are already in place, automatic stabilizers only face an impact lag.

Election Cycles

Since the Great Depression, the expansionary periods have been longer than the contractionary periods, so a large debt should not be an issue.
One theory is that there is a conflict between election cycles and the business cycle.
Governments find it hard to make budget cuts and raise taxes, especially when they are thinking about being re-elected.
Generally, in the first two years of their mandate, governments make the toughest spending cuts.
The nearer the time for an election, the harder it is to make spending cuts.
A government that wants to be re-elected is more likely to increase spending and decrease taxes, running a budget deficit even when the economy does not need it.
It is also difficult to convince the electorate that the government should collect more in taxes than it spends, which is necessary to run a surplus budget to pay down the debt.
People seem to want government help when times turn tough but object to being "overtaxed" when the expansion years arrive.

Regional Variations

Regional variations may interfere with the implementation of fiscal policy.
If part of the country is doing well while another region is suffering from a slowdown, what policy should be used?
An expansionary fiscal policy would likely cause inflation in the region doing well, yet a contractionary fiscal policy would make the recession worse in the part of the country suffering a slowdown.
Targeting fiscal policy to a specific region does not work very well.
While initial government spending and taxation policies could be targeted at a specific region, it is likely that the impact of the fiscal policy would be spread well beyond the specific region once the multiplier effect is fully felt.
Conflict between the various levels of government regarding the appropriate fiscal policy might limit its effectiveness.
If the federal government is reducing spending and increasing taxes to slow down economic growth, and a powerful provincial government is increasing spending and cutting taxes to gain political support, the two policies would be at odds, limiting the desired impact on economic conditions.

Impact on Investment

Another potential concern about the use of fiscal policy is that a crowding out of private investment may occur when the government competes with the private sector to borrow funds to finance the debt.
Crowding out: The theory that government borrowing drives up interest rates and reduces the amount of loanable funds, thereby making it more difficult for businesses to borrow.
Some economists argue that expansionary fiscal policy drives up interest rates as the government competes in the market for loanable funds and subsequently reduces the amount of funds available for private investment.
As a result, private investment in capital goods decreases, and the rate of economic growth slows.
In this case, the government is simply replacing government spending for investment spending with no net impact on GDP.

Income Equity

Deficits redistribute income from all taxpayers to bondholders.
The government sells bonds and treasury bills to finance some of that debt, which are known as marketable debt.
Approximately 70 percent of the federal marketable debt was in the hands of Canadians, while 30 percent was held by foreign investors in 2017.
Most government bondholders are corporations or those with above-average incomes.
Creating debt and financing it through bonds redistributes income from the poor to the rich in society because most income earners pay taxes, but the interest payments go only to bondholders.

Burden on Future Generations

Deficits impose a net burden on future generations because citizens at some point in the future will have to pay that money back, or at least maintain the interest payments, in the form of taxes.
This concern largely depends on what the deficit is used to finance.
If the money is spent on economic infrastructure, such as roads or buildings, then future generations will get the benefit of using those expenditures.
However, if the deficit is generated by funding current expenditures, such as employee salaries or EI payments, then future generations will derive no net benefit from the debt that is created.