Roles and Objectives of Fiscal Policy

Roles and Objectives of Fiscal Policies

The primary goal of the fiscal policy is to control the economy of a given country by influencing the aggregate national output, which is basically real GDP.

Fiscal Policy and Aggregate Demand

Aggregate demand is the total amount that households and businesses intend to spend. Fiscal policy can boost overall demand through:

• Decreasing corporation taxes stimulates business profits and expenditures.
• Introducing new public expenditures for social welfare and infrastructure projects.
• Reducing personal income tax resulting in increased disposable income.
• Lowering sales taxes leads to decreased prices for consumers.

Note that the effectiveness of the Fiscal policies on aggregate demand, changes over time, and economy to economy. Economists fall into two opposing categories about the effectiveness of fiscal policy: Keynesians and Monetarists.

According to Keynesians, fiscal policy can substantially affect aggregate demand, economic output, and employment, especially when an economy has a notable amount of unused capacity.

Monetarists hold a different view. They argue that fiscal changes provide only a temporary impact on aggregate demand. Instead, they stress that monetary policy is a more effective tool for managing or amplifying inflationary pressures.

During economic downturns, governments have the option to increase expenditures (expansionary fiscal policy) in an effort to elevate employment and production.

Conversely, during periods of economic prosperity characterized by full employment and rapid wage and price growth, governments may opt to curtail spending and enhance taxes (contractionary fiscal policy).

Recall that budget surplus is the positive difference between government revenue and expenditure for a fixed period of time, such as a fiscal or calendar year. The budget deficit is the opposite of the budget surplus: the negative difference between government revenue and expenditure.

Often, analysts analyze the fluctuations of budget surplus or deficit from year to year to ascertain whether the fiscal policy is expansionary or contractionary. Specifically, an increase in budget surplus implies contractionary fiscal policy, while an increase in budget deficit implies expansionary fiscal policy.

Automatic Stabilizers

Automatic stabilizers are fiscal policies that automatically adjust tax rates and transfer payments in a manner that is intended to stabilize incomes, consumption, and business spending over the business cycle.

Note that automatic stabilizers work automatically, without the need for policymakers to identify shocks.

For instance, when the economy slows down and unemployment rises, the government’s spending on social insurance and unemployment benefits will increase. This will boost aggregate demand, helping to prevent the economy from contracting further.

On the other hand, if the economy is booming, with high employment and incomes, then progressive income and profit taxes will rise. This progressive taxes take a larger percentage of income from high-income earners than low-income earners. As incomes rise, so do tax revenues. This will help to reduce the budget deficit or increase the budget surplus.

Automatic stabilizers are different from discretionary fiscal policies. Automatic stabilizers are built into the tax and transfer system and automatically adjust in response to economic changes. On the other hand, discretionary fiscal policies are implemented by the government in response to a specific economic event or shock.

Deficits and the National Debt

A government deficit occurs when it spends more than it collects in taxes and other revenue. The national debt is the accumulation of the government deficits over time.

The solvency of a country can be assessed using the ratio of debt to GDP and the ratio of interest payments to GDP.

The interpretation of the debt-to-GDP ratio is straightforward. A country’s solvency is considered to be in jeopardy when its debt-to-GDP ratio reaches a level that is considered to be unsustainable.

The ratio of interest payments to GDP measures government payments to service the debt as a percentage of national output.

Is it a cause for concern if a country’s national debt is large relative to its gross domestic product (GDP)? There are arguments, both opposing and supporting, whether the size of a national debt relative to GDP matters.

Arguments Opposing that National Debt Matters

• The national debt is not as big of a problem as it seems because most of it is owed to people and institutions within the country.
• Some of the debt that the government borrowed was used to finance productive investments, such as infrastructure and education. These investments can lead to increased economic output and tax revenues in the future.
• Substantial fiscal deficits may call for tax reforms that eliminate distortions caused by existing tax systems.
• Ricardian equivalence: Fiscal deficits might not have a net effect as the private sector could counterbalance it by boosting their savings, expecting taxes to rise in the future.
• When an economy experiences unemployment, debt is not necessarily redirecting activities away from productive purposes. In fact, the debt could potentially be linked to a rise in employment.

Arguments Supporting that National Debt Matters

• A high debt-to-GDP ratio might result in increased tax rates as there is a search for greater tax revenues. This could cause a lack of motivation for economic activities because elevated marginal tax rates decrease labor input and entrepreneurial actions, ultimately resulting in diminished growth over time.
• If the financial markets start to doubt a government’s capabilities, the central bank might be forced to print money to finance the government deficit. This is because when confidence is lost, it becomes harder for the government to borrow money by selling bonds, as investors may demand higher interest rates or be unwilling to buy the bonds.
• Government borrowing can sometimes hinder investment by the private sector, a phenomenon called ‘crowding out.’ If there is a limited pool of savings available for investment, increased demand from the government will result in increased interest rates, leading to decreased investment by the private sector.

Question

Which one of the following is most likely a disadvantage of national debt?

1. The national debt can cause inflation.
2. A country acquires additional funds for growth.
3. The national debt can stimulate economic growth in the short term.

Solution

The correct answer is A.

Excessive national debt can lead to inflation, especially if the government resorts to printing money to service its debt. This is considered a disadvantage as inflation erodes the purchasing power of a currency and can lead to a host of other economic problems.

B is incorrect. By borrowing money, the government can acquire additional funds that can be invested in projects that promote economic growth. For example, the government can invest in infrastructure projects to create jobs and stimulate economic activity. However, it is important to manage the level of debt carefully to ensure that it does not become unsustainable. Additionally, the effectiveness of this approach depends on the government’s ability to invest the borrowed funds wisely and generate a return on investment that exceeds the cost of borrowing.

C is incorrect. This is considered an advantage because, by borrowing funds, the government can invest in infrastructure, public services, and other projects that can stimulate economic activity, create jobs, and lead to economic growth. This can be particularly important during times of economic downturn when private sector investment is low. However, managing the debt levels carefully is crucial to ensure it does not become unsustainable in the long term.