7: The Government Sector

The federal governments in Canada and their budget policies generated a lot of media coverage and public debate in 2015 and 2016. Minister of Finance, Joe Oliver, in his April 2015 Budget Plan delivered on the Harper Government's promise to balance the budget in 2015. But politics aside there really is no magic to a balanced budget. A balanced budget does not reduce the public debt. Nor does a balanced budget directly increase economic activity in an economy operating with a recessionary gap. Perhaps more interestingly, the government's actual budget balance at the end of its budget year depends importantly on the growth and level of GDP. As it turned out, at the end of the fiscal year 2015–16 actual growth in GDP was less than assumed in the budget plan and the actual budget was in deficit. The public debt as measured by the accumulated deficit continued to increase.

During the general election campaign of 2015 the Liberal Party proposed a sharp change in budget policy. Citing the low growth rates in the economy and an increase in the unemployment rate they promised to stimulate the economy by running budget deficits to finance major infrastructure projects. Minister of Finance Bill Morneau's budget plan of April 2016 forecast the first of these deficits. The underlying argument was that increased government expenditure would lead to increased GDP and employment. Fiscal policy was then focused on improvements in economic activity in contrast to the previous governments focus on balancing the budget. This chapter explains these issues and the role of government in the economy.

A government sector adds important new linkages and feedback effects to the basic model of Chapter 6. Government expenditures on goods and services (G), determined by government policy, are added to other autonomous expenditures. They affect AE and equilibrium income through the multiplier. Government revenue collected by a net tax rate (t) applied to national income reduces the income households have to spend on consumption and reduces induced consumption expenditure. The multiplier is reduced, reducing equilibrium national income and the effects of changes in autonomous expenditure on equilibrium national income.

The linkages and feedbacks work in both directions. Changes in government expenditures and taxes have effects on equilibrium national income. Government can use these effects to manage aggregate expenditure and equilibrium income. However, changes in equilibrium national income caused by changes in expenditure in other parts of the economy changes incomes, government revenues and budget balances. As a result, changing economic conditions often lead to government budget outcomes that differ from initial targets and projections as in 2016.

Furthermore, over time governments must manage their budgets in ways that control the size of their debt relative to GDP. The fiscal policy governments implement through their budgets has dual objectives: Manage aggregate demand and, over time, manage the size of the public debt relative to national income. Until recently, Canadian governments have been more concerned about government budget surpluses, deficits, and debt than about demand management when designing fiscal policy.

To explain the role of government in macroeconomic analysis and policy, we start with a brief look at the data on the size of the government sector in Canada.