BUS171 Topic 12

Fiscal Policy Overview

Goals of Fiscal Policy

• Government and central bank macroeconomic policies aim to stabilize the economy.

• Achieve objectives such as:

  • Smooth economic fluctuations.

  • Prevent fluctuations from occurring.

• Types of macroeconomic policy:

  • Demand management policy (short run).

  • Supply-side policy (long run).

Government Expenditure and Revenue

Government Expenditure

• Comprises:

  • Government purchases (G).

  • Transfer payments (e.g., pensions, unemployment benefits).

• Historical fluctuation:

  • Between 18% and 27% of GDP over recent decades.

  • Reached 35% in 2020-21 due to COVID-19 pandemic.

• Major expenditures:

  • Social security and welfare: ~35%.

  • Health: ~16%.

  • Education: ~7%.

  • Defence: ~6%.

Sources of Revenue

• Primarily derived from:

  • Individual income tax: ~48%.

  • Company income tax: ~18%.

  • Goods and Services Tax (GST): 15% (transferred to states/territories).

Understanding Fiscal Policy

Definition

• Fiscal policy involves changes in:

  • Federal government taxes.

  • Transfer payments and purchases.

• Goals of fiscal policy include:

  • Achieving high employment.

  • Maintaining low and stable inflation.

  • Ensuring healthy economic growth.

Types of Fiscal Policy

Automatic Stabilisers

• Existing government policies that automatically adjust with the business cycle.

  • Example: Taxes and transfer payments react without new legislation.

Discretionary Fiscal Policy

• Actions taken by the government to modify spending, taxes, or transfer payments intentionally.

Expansionary Fiscal Policy

Explanation

• Involves:

  • Increasing government purchases.

  • Increasing transfer payments.

  • Decreasing taxes to boost aggregate demand (AD).

Mechanisms

• Directly increases AD through government purchases (G).

• Indirectly increases AD via disposable income adjustments through taxes and transfer payments.

Goals

• To shift the AD curve further to the right than it would have occurred without intervention.

• Appropriate in conditions of:

  • Equilibrium below full employment (e.g., recession).

Contractionary Fiscal Policy

Definition

• Involves:

  • Decreasing government purchases.

  • Increasing taxes.

Purpose

• Aims to decrease aggregate demand growth to control inflation.

• Used when the economy is operating above full employment, facing high inflation.

Measures

• Reduce government spending.

• Increase taxes.

• Non-indexation of transfer payments.

The Multiplier Effect

Description

• The concept that an increase in autonomous expenditure (e.g., government purchases) leads to a more than pro-rata increase in real GDP.

  • As one person’s spending becomes another’s income, a chain reaction occurs.

Challenges of Fiscal Policy

Key Difficulties

• Time Lags:

  • Recognition lag: Time to identify an economic issue.

  • Legislative lag: Time to pass legislation.

  • Implementation lag: Time to enact policy.

  • Impact lag: Time for policy effects to manifest.

  • Total lag can be up to 18 months.

• Crowding Out:

  • Increased government spending leading to decreased private sector spending due to resource competition.

• Uncertainty:

  • Inaccuracies in estimating the multiplier effect.

  • Potential rise in inflation from extensive government borrowing.

Automatic Stabilisers

Functionality

• Embedded within government policies to stabilize the economy without needing new legislation.

• Examples include:

  • Marginal personal income tax rates.

  • Transfer payments that automatically adjust with GDP changes.

Long-run vs Short-run policies

Demand Management Policies

• Fiscal policies primarily aimed at short-term economic adjustments.

• Involves reallocating resources from the private to the public sector.

Supply-side Policies

• Designed to foster long-term economic growth by:

  • Enhancing labor, capital, resources, and entrepreneurship.

  • Shifting long-run aggregate supply (potential GDP) to the right.

Potential Measures

• Tax reductions to boost work/investment incentives.

• Simplifying the tax system.

• Investing in education, training, infrastructure, and competitive markets.