Chapter 23 - Government Spending, Taxes, and Fiscal Policy

The Government Sector

  • Government Spending: Government spending has increased over time due to the government's expanded role in providing social insurance and education.
  • Social Insurance: Government-provided insurance against adverse outcomes like unemployment, illness, disability, or outliving savings.
  • Federal Spending:
    • Social insurance programs constitute a significant portion.
    • Military spending.
  • Federal Government Revenue Sources:
    • Sales taxes
    • Income taxes
    • Corporate taxes
  • Provincial Spending:
    • Health insurance programs
    • Education
    • Transportation
  • Provincial Government Revenue Sources:
    • Income taxes
    • Sales taxes
    • Royalties and Crown corporations
  • Local Spending:
    • Community services
  • Local Government Revenue Sources:
    • Property taxes
    • Fees
  • Hidden Government Spending: Ways the government effectively spends money without it appearing on their books.
    • Tax expenditures: Special deductions, exemptions, or credits that lower tax obligations to encourage certain activities.
    • Government regulation: Mandating that citizens or businesses engage in specific behavior that costs money.

Total Government Spending

  • In 2021, provincial governments spent 575 billion, the federal government spent 493 billion, local governments spent 191 billion, and Aboriginal governments spent 19 billion.
  • This amounts to approximately $33,000 per person in Canada.

Federal Government Spending

  • The federal government is often described as an insurance company with a military.
  • Social insurance programs, along with defense and public safety, account for roughly 58% of federal spending.
  • Social insurance programs include government-provided insurance against negative outcomes such as unemployment, illness, disability, or outliving one's savings.
  • Interest on debt accounts for 9% of federal spending, leaving 42% for other categories like education, environmental protection, culture, recreation, transportation, and foreign aid.

Provincial and Local Government Spending

  • Provinces are responsible for education and health care, with health care consuming over a third of their budgets.
  • Local governments provide services like recreation, culture, transportation, public safety, housing, garbage pickup, police, and playgrounds.

Government Spending Comparison

  • Canada's government spending is in the middle range compared to other rich countries.

Federal Government Revenue

  • The federal government primarily collects revenue through income taxes, with half of its revenue coming from individual income taxes.
  • Payroll taxes are taxes on earned income. In 2022, the payroll tax for the Canadian Pension Plan was 5.7% on earnings up to 64,900, and for Employment Insurance, the rate was 1.58% up to 60,300.
  • Income taxes are collected on all income, including earned income from working and unearned income like investment income, pensions, and capital gains.
  • Income is the money received in a year, distinct from wealth, which represents savings and assets.

Income Tax Details

  • Income taxes are progressive, meaning the tax rate increases with income, based on taxable income.
  • Taxable income is calculated as total income minus deductions.
  • Marginal tax rate: the tax rate paid on an additional dollar of income.
  • 2022 Federal Tax Rate Schedule:
    • 0 - $50,197: 15%
    • $50,197 - $100,392: 20.5%
    • $100,392 - $155,625: 26%
    • $155,625 - $221,708: 29%
    • Over $221,708: 33%

Corporate Taxes

  • Sixteen percent of federal taxes are collected from corporations.
  • Corporate taxes are ultimately paid by individuals, including owners and workers.
  • Increased corporate taxes can lead to businesses investing less in capital, reducing worker productivity and wages.
  • For every dollar of corporate tax, shareholders lose approximately 75 cents, and workers lose about 25 cents.

Hidden Government Spending: Tax Expenditures

  • Tax expenditures are special deductions, exemptions, or credits that lower tax obligations to encourage specific activities.
  • Example: The Volunteer Firefighters’ Amount allows a tax credit of 450 for volunteering at least 200 hours a year as a firefighter.
  • Tax expenditures have a lower political cost because they are part of the tax code and receive less scrutiny.
  • Tax breaks encourage spending on employer-provided supplemental health insurance, retirement savings, and homeownership.

Hidden Government Spending: Government Regulation

  • Government can disguise spending by mandating others to pay for it through regulation.
  • Example: Requiring employers to pay sick leave shifts the cost from the government to employers and workers.
  • Regulation can alter incentives. For instance, mandated sick leave might discourage employers from hiring workers perceived as more likely to get sick.

Fiscal Policy

  • Fiscal policy: The government’s use of spending and tax policies to stabilize the economy.
  • Aims to minimize output fluctuations and maintain actual GDP close to potential output.
  • Fiscal policy is countercyclical, counteracting the effects of the business cycle.
  • Expansionary fiscal policy: Increases government spending and lowers taxes to boost aggregate demand and GDP during weak economic periods.
  • Contractionary fiscal policy: Decreases government spending and raises taxes to weaken aggregate demand and lower GDP during overheating economic periods.

Government Spending and GDP

  • Government spending can directly and indirectly add to GDP.
    • Direct effect: Government purchases increase aggregate expenditure, boosting GDP.
    • Indirect effect: Transfer payments increase household spending, which boosts aggregate expenditure.
  • The multiplier effect amplifies the impact of fiscal policy; an initial boost in spending creates ripple effects, leading to a larger rise in GDP.

Discretionary Government Spending

  • Discretionary government spending can involve substantial time lags.
  • Delays occur in recognizing the need for action, formulating and passing legislation, and finding suitable projects for spending.

The Three Ts of Fiscal Policy

  • Fiscal policy is most effective when it's timely, targeted, and temporary.
    • Timely: Policymakers must act quickly.
    • Targeted: Focus on specific regions, industries, and groups needing the most help.
    • Temporary: Extra spending should cease once the economy recovers.

Crowding Out

  • Crowding out: The decline in private spending, particularly investment, that follows a rise in government spending.
  • Expansionary fiscal policy can lead to higher real interest rates, reducing private spending by decreasing the supply of loanable funds!

Automatic Stabilizers

  • Automatic stabilizers: Fiscal policy (spending and tax programs) that adjusts as the economy expands and contracts without deliberate action by policymakers.
  • These adjustments are countercyclical: boosting output during recessions and reducing output during expansions.
  • The progressive tax system helps counter both booms and busts, with tax brackets adjusting automatically.
  • Spending on government support programs adjusts automatically during business cycles.

Advantages of Automatic Stabilizers

  • Automatic stabilizers are timely, targeted, and temporary.
    • Timely: Automatically triggered when incomes decline.
    • Targeted: Taxes decline only for those with reduced income, and support is directed to eligible individuals.
    • Temporary: Automatically reverse course as the economy recovers.

Fiscal vs. Monetary Policy

  • Monetary policy is more nimble, with quick implementation, but its effects on spending can take a year or more.
  • Fiscal policy can be more targeted, addressing specific sectors or regions affected by economic shocks.
  • Fiscal policy is particularly important at the zero lower bound when the central bank cannot lower short-term nominal interest rates further.

Government Deficits and Debt

  • Budget deficit: The difference between spending and revenue in a year when spending exceeds revenue.
  • Budget surplus: The difference between spending and revenue in a year when revenue exceeds spending.
  • Government debt: The total accumulated amount of money that the government owes.

Facts About Government Spending and Revenue

  1. Since 1997, the federal government has run budget surpluses about half the time.
  2. Persistent, large budget deficits occurred in the 1970s, 1980s, and 1990s.
  3. Wars and pandemics necessitate sudden surges in spending, resulting in budget deficits.
  4. Business cycles create budget deficit cycles.

Perspectives on Budget Deficits

  • Typical perspective: Budget deficits reflect a mismatch between government spending and revenue.
  • Alternative perspective: Budget deficits reflect a mismatch between when the government spends and when it receives revenue.
  • Deficits can be justified for multigenerational investments like infrastructure, research, and airports.

Political Incentives and Balanced Budgets

  • Budget deficits may arise from short-run political incentives; spending programs are popular, while raising taxes is not.
  • Requiring a balanced budget could worsen business cycles by preventing fiscal policy from counteracting economic downturns.
  • In a recession, lower tax revenues would force cuts in government support programs or higher taxes, reducing aggregate expenditures and further declining output.

Government Debt Details

Government debt: The total accumulated amount of money that the government owes.

  • Reflects past borrowing to fund budget deficits and repayments from surpluses.
  • The government borrows by selling government bonds to savers.
  • Gross government debt: 1.2 trillion in 2021.
  • Net government debt: Gross debt minus financial assets; in Canada, it was 33% of GDP in 2020.

Arguments Against Worrying About Government Debt

  1. Most government debt is owed by Canadians to Canadians.
  2. Future generations can help repay the debt.
  3. It wouldn’t take a big adjustment to repay the debt.
  4. The government never really needs to repay the debt.
  5. The government has options that you don’t, such as raising taxes or printing money.

Reasons To Worry About Government Debt

  1. Slower economic growth. The government borrows funds that might otherwise be used to finance investments in productive capital
  2. Future fiscal choices are constrained
  3. The risk of a crisis of confidence
  4. A debt crisis becomes more likely

Key Takeaways: Government Deficits and Debt

  • Budget deficit: Spending exceeds revenue in a year.
  • Budget surplus: Revenue exceeds spending in a year.
  • Gross government debt: Total accumulated amount of money the government owes.
  • Net government debt: Debt owed to individuals, businesses, and other governments here and abroad.
  • There are valid reasons for and against concern about government debt.

Chapter 23 Summary

  1. Government’s role in social insurance and education has expanded.
  2. Discretionary fiscal policy and automatic stabilizers.
  3. Debt is a stock measure, while the deficit is a flow measure.