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7.4: Fiscal Policy and Government Budget Balances

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  • Fiscal policy is the government’s use of its taxing and spending powers to affect aggregate expenditure and equilibrium real GDP. The main objective of fiscal policy is to stabilize output by managing aggregate demand, keeping output close to potential output, and reducing the size and duration of business cycle fluctuations. This requires changes in the government’s expenditure plans and tax policy to offset changes in autonomous consumption, investment and exports that would otherwise push the economy away from equilibrium at potential output.

    In 2008 and 2009, for example, the international financial crises and the recession that followed led to fiscal stimulus programs in most industrial countries, like Canada’s federal ‘Economic Action Plan’, and calls for international coordination of fiscal stimulus. This fiscal stimulus led in turn to increased budget deficits and national debts and, especially in Europe, to sovereign debt crises. We return to this important issue in Section 7.7.

    Fiscal policy: government use of taxes and spending to affect equilibrium GDP.

    Figure 7.5 illustrates the use of fiscal policy to eliminate output gaps. In the diagram on the left, the economy has a recessionary gap at Y0 < YP because aggregate expenditure is not high enough to give equilibrium at YP.

    Screenshot 2019-03-23 at 22.53.40.png

    Figure 7.5: Fiscal Policies to Eliminate Recessionary and Inflationary Gaps
    a) An increase in government spending increase Y and closes recessionary
    b) Increase in the tax rate reduces spending and the multiplier to close in-
    flationary gap.

    Government can intervene to raise AE to AE1 by increasing government expenditures or by lowering the net tax rate or a combination of the two. In this case, the government chooses to increase G. Working through the multiplier the increase in G moves the economy to equilibrium at potential output.

    The right-hand diagram in Figure 7.5 shows a fiscal policy response to an inflationary gap. Again the government can choose between changing expenditures and changing the tax rate. In this example, an increase in the net tax rate reduces the slope of AE and moves the economy to equilibrium at YP.

    Fiscal policy makes changes in net tax rates and government spending that are intended to change aggregate expenditure and aggregate demand and stabilize equilibrium output at potential output. These changes also change the government’s budget function. An important question we need to consider is if the observed budget balance—whether surplus, balanced, or deficit—is a good measure of the government’s policy intention or fiscal stance.

    Does the budget balance show whether fiscal policy is expansionary, aiming to raise national income, or contractionary, trying to reduce national income?

    In itself, the budget balance may be a poor measure of the government’s fiscal stance, because the budget balance can change for reasons unconnected to fiscal policy. Even if G and t are unaltered, a fall in investment or exports will reduce national income and output. In turn, this reduces net tax revenue and reduces the budget balance. Indeed, any change in non-government autonomous expenditure changes equilibrium income, net tax revenue, and the government’s budget balance.

    For given levels of government expenditure and tax rates, the budget function shows us that the budget balance is smaller in recessions, when national income is low, than in booms, when income is high. Suppose autonomous aggregate expenditure and demand fall suddenly. The budget may go into deficit. Someone looking only at that deficit might conclude that fiscal policy had shifted toward expansion with an increase in expenditure or a cut in the net tax rate, and no further fiscal stimulus was needed. That might be wrong. The deficit may be caused by the recession, not by a change in policy.

    Recent Canadian experience provides a good example. The Minister of Finance in his budget of February 2008, provided a fiscal plan based on a projected rate of growth in nominal GDP in 2008 of 3.5 percent and in 2009 of 4.3 percent. Under this plan and these growth rates, the projected budget surplus for the fiscal year 2008-2009 was $2.3 billion. However, the financial crisis in the U.S. and the U.S. recession that developed in the last quarter of 2008 along with the drop in energy and commodities prices undermined the Minister’s GDP growth projections. By the time of his Economic and Financial Statement of November 2008 he was projecting much smaller budget surpluses of $0.8 billion in fiscal 2008-2009 and $0.1 billion in fiscal 2009-2010. In terms of the budget function in Figure 7.4, the budget balance had moved to the left and down the budget function.

    The Structural Budget Balance

    To use a budget balance as an indicator of fiscal stance, we calculate the structural budget balance (SBB). This is an estimate of what the budget balance would be if the economy were operating at potential output. By evaluating the budget at a fixed level of income, namely potential GDP, the structural budget balance does not change as a result of business cycle fluctuations in output. In terms of the budget function we used above, the structural balance is:

    \[SBB = tY_p - G\]

    Structural budget balance (SBB): the government budget balance at potential output.

    Notice that this structural budget function differs from the general budget function of Equation 7.7 by calculating net tax revenue at YP rather than at any Y.

    Using the previous numerical example, suppose government expenditure is 200 and the tax rate is 0.20. As in Figure 7.5, the budget balance is a deficit at any income below 1000 and a surplus at any income above 1000. If, given other components of aggregate expenditure, the equilibrium output is 800, the actual budget balance will be a deficit. Net tax revenue will be \(NT = 0.2 × 800 = 160\). With government expenditure of \(G = 200\), \(BB = 160 − 200 = −40\).

    Conversely, suppose higher AE makes equilibrium output 1200. With a tax rate of 0.20 and government expenditure of 200, the budget balance would be a surplus of 40. The important point of these examples is that we cannot tell the stance of fiscal policy, or a change in the stance of fiscal policy, by looking at the actual budget balance. We need to look at a structural budget balance, calculated at potential output (YP) that is not changed by business fluctuations in actual output around potential output.

    Changes in the government’s fiscal policy program change the structural budget balance and shift the budget function. An increase in government expenditure on goods and services, for example, would shift the BB line in Figure 7.6 down and lower the structural budget balance. The AE line would shift up and increase equilibrium income and aggregate demand. This would be an expansionary fiscal policy.

    Screenshot 2019-05-18 at 01.06.41.png

    Figure 7.6: Actual and Structural Budget Balances
    Structural budget balance \(SBB_0 = t_0Y_p - G_0\). Actual budget balance
    \(BB_1 = tY_1 - G0\).

    A change in the net tax rate would also change the structural budget balance and the budget line BB in the diagram. In this case, the slope of the line would increase with an increase in the tax rate or fall with a cut in the tax rate. In either case it would be the change in the structural budget balance that would tell us that fiscal policy had changed and whether the change would increase or reduce aggregate expenditure.

    Figure 7.7 shows the difference between actual and structural budget balances for one fiscal policy program and budget. The budget program BB0 would give a structural budget deficit BB1 if the economy were in equilibrium at Y1.

    However, if higher autonomous investment or exports increased AE to give equilibrium at potential output YP the budget program would have its structural balance SBB0. Still higher AE would give equilibrium output greater than YP, at Y2 for example, and create a larger budget surplus, BB2.