Lecture Notes: Fiscal Policy and Public Finances

Economics for Business I - Macroeconomics - Lecture 9

Fiscal Policy and Public Finances

Fiscal Policy

• Definition: Fiscal policy involves changing government expenditure (G) and/or taxation (T) to influence aggregate demand (AD).
• Expansionary Fiscal Policy:
  • Raising G and/or reducing T.
  • Used to stimulate economic activity.
• Deflationary/Contractionary Fiscal Policy:
  • Reducing G and/or raising T.
  • Used to curb inflation.

Roles for Fiscal Policy

• Correcting Fundamental Disequilibrium: Addressing underlying imbalances in the economy.
• Preventing Severe or Prolonged Recession:
  • Expansionary fiscal policy used during crises like the Global Financial Crisis and the COVID-19 pandemic.
• Preventing Rampant Inflation:
  • Deflationary fiscal policy used during periods of high inflation, such as the 1970s or the post-COVID-19 period.
• Stabilization Policies:
  • Smoothing out fluctuations in the economy associated with the business cycle.
  • Reducing G or raising T during economic booms.
  • Cutting T or raising G to boost the economy during recessions.
• Influencing Aggregate Supply:
  • Increasing G on education, training, health, and infrastructure.
  • Providing tax incentives for investment and research and development (R&D).
  • Implementing policies aimed at protecting businesses and jobs during crises like the COVID-19 pandemic.

Government Finances

• General Government Deficit (or Surplus): The combined deficit (or surplus) of central and local government.
• Budget Deficit: The excess of government spending over its tax receipts.
• Budget Surplus: The excess of government tax receipts over its spending.
• General Government Debt: The accumulated deficits of central plus local government; the total amount owed by general government, both domestically and internationally.
• National Debt: The accumulated deficits of central government; the total amount owed by central government, both domestically and internationally.

Public Sector Finances

• Composition: The public sector includes the central and local government, and public corporations.
• Ownership: Corporations can transfer between public and private ownership through privatization (e.g., transport, energy, and telecommunications).
• Government Support: Government support is crucial during crises like the Global Financial Crisis (banking sector) and the pandemic (transport sector).
• Public-Sector Net Borrowing (PSNB): The difference between the expenditures of the public sector and its receipts from taxation and the revenues from public corporations.
• During the Covid-19 pandemic, UK public-sector spending and PSNB reached highest levels since the Second World War

Current vs Capital Expenditure

• Current Expenditure: Recurrent spending on goods and factor payments.
  • Includes operational expenditures of the public sector, such as wages and salaries of public-sector staff, and payments of welfare benefits.
• Capital Expenditure: Investment expenditure; expenditure on assets.
  • Includes public sector investment, for example, in roads, hospitals, and schools.
  • Capital expenditures generate long-term economic benefits.
• Historical Data (UK):
  • Since 1960, UK public-sector spending averaged 40% of GDP.
  • Current spending averaged 34% of GDP.
  • Capital spending averaged just 6% of GDP.
• Impact: UK’s comparatively low share of public and private investment in GDP may explain lower growth of labor productivity compared to competitor countries.

Fiscal Indicators

• Purpose: Assess the sustainability of public sector’s finances.
• Net Borrowing: Government or public-sector expenditures minus receipts.
• Net Debt: Gross government or public-sector debt minus liquid financial assets.
• Current Budget Deficit: The amount by which government or public-sector expenditures classified as current expenditures exceed public-sector receipts.
• Primary Surplus (or Deficit): The situation when the sum of government or public-sector expenditures excluding interest payments on its debt is less than (greater than) the sector’s receipts.

Use of Fiscal Policy

• Automatic Fiscal Stabilizers: Tax revenues that rise and government expenditure that falls as national income rises.
• Discretionary Fiscal Policy: Deliberate changes in tax rates or the level of government expenditure in order to influence the level of aggregate demand.

Effectiveness of Discretionary Fiscal Policy

• Magnitude:
  • It’s challenging to predict the macroeconomic effects of changes in G and T.
  • Crowding out: Public expenditure diverts resources away from the private sector.
• Timing:
  • Fiscal policy involves time lags: recognition/action/effect.
  • Consumption may respond slowly to changes in taxation.
• Side-effects:
  • High tax rates may discourage effort and initiative.
  • Generous unemployment benefits may increase equilibrium unemployment.

Fiscal Rules

• Benefits:
  • Reduce uncertainty and encourage companies to invest.
  • Prevents government manipulating economy for electoral purposes (avoids a political business cycle).
• Downsides:
  • May no longer be appropriate and require changing.
  • Important to be able to respond to a crisis, such as COVID-19.

Lecture Summary

1. Discretionary fiscal policy is where the government deliberately changes taxes or government expenditure in order to alter the level of aggregate demand
2. Public sector net borrowing and debt have increased in recent times
3. Fiscal indicators are used to assess the sustainability of public sector finances.