Tools of Fiscal Policy

The tools that governments use ton influence the economy can be divided into spending and revenue tools. Spending tools refer to the overall government spending while revenue tools refer to taxes collected by the government.

Government Spending Tools

Capital Expenditure

Capital expenditure refers to what a government spends on amenities such as schools, roads, and hospitals. This spending adds to a country’s capital stock and affects its productive potential.

Current Government Spending

Current government spending is expenditure on goods and services like defense, health and education which it provides on a recurring and regular basis. Such spending heavily impacts a country’s skill level and its overall labor productivity.

Transfer Payments

Transfer payments are payments that the government makes through the social security systems. An example of transfer payments is umemployment benefits. They ensure a minimum level of income for low-income individuals and provides ways for governemnts to change the distribution of income in society.

Transfer payments are not included in the calculation of the GDP for two reasons:

1. They do not reflect a reward to a factor of production for economic activity.
2. They are not considered a part of general government spending on goods and services.

Justifications for Government Spending

• By spending to provide services such as defence, the government benefits all its citizens equally.
• Infrastructure spending helps grow a country’s economy.
• Welfare and related benefits assures the less-wealthy individuals a certain minimum income level, and redistributes income and wealth
• By managing aggregate demand, the government influences its economic objective of low inflation and high employment and growth.
• To subsidize costs for the creation of risky but inventive new items.

Government Revenue Tools

Indirect Taxes

Indirect taxes refer to taxes (excise duties) imposed on specific goods such as cigarettes, alcohol, fuel, and services. VAT is an example of an indirect tax. Health and education can be excluded from indirect taxes.

Direct Taxes

Levies on profit, income, and wealth are direct taxes. Taxes charged on a deceased property can both raise revenue and distribute wealth. They include capital gains tax, national insurance tax, and corporate taxes.

Taxes increases revenues to finance expenditures and help redistribute income and wealth.

Desirable Qualities of a Tax Policy Desirable:

1. Simplicity: This means taxes should be easy for people to follow and for tax agencies to enforce.
2. Efficiency: Taxes shouldn’t disrupt individual choices in the market. They should disrupt work and investment only to a small extent.
3. Fairness: Similar situations should lead to similar tax payments (horizontal equity), and wealthier individuals should pay more (vertical equity).
4. Adequate Revenue: Taxes should generate enough money for government needs, although this might clash with the principles of fairness and efficiency.

Problems Related to Tax Policy

1. Incentives: Some economists are of the opinion that income taxes diminish the motivation to work, save, and invest and that the cumulative tax load has become too much.
2. Fairness: Determining the fairness of the tax system can be challenging. One approach is to measure the tax burden borne by various population segments, categorized by their income levels, and then evaluate how tax alterations impact these groups. Naturally, this approach requires extensive data collection and analysis, making it a demanding task for researchers and, hence, should be regarded as incomplete.
3. Tax reform: Discussions about modifying tax policies are ongoing. Various questions arise, such as: Should a uniform tax rate be applied to labor income? Should all investments be instantly deductible from corporate taxes?

Advantages of Different Fiscal Policy Tools

• Indirect taxes can be be adjusted quickly after they have been announced and can influence spending behavior instantly and generate revenue for the government at a negligible or zero cost to the government.
• Social policies such as discouraging the consumption of alcohol or tobacco can be quickly implemented by increasing taxes on these products.

Disadvantages of Using Different Fiscal Policy Tools

• Direct taxes, such as income taxes, are challenging to alter without significant notice, often requiring several months, as payroll computer systems need adjustments.
• Plans for capital expenditures, such as infrastructure projects, typically require an extended period, often several years, to fully develop and execute. For example, constructing infrastructure like roads or hospitals involves detailed planning, securing legal authorizations, and the actual execution, each of which takes considerable time.

The Fiscal Multiplier

The Fiscal multiplier assists in modeling the effect of Taxes and government spending on aggregate demand.

Typically, a conventional macroeconomic model posits that government spending (G) directly increases aggregate demand (AD) while reducing it through taxes (T). Payments of transfer benefits like social security payments also increase government spending. As such, the net effect of the government sector on the aggregate demand is mathematically expressed as:

$$ G-T+B=\text{Budget Surplus or Deficit} $$

Denote the net taxes (taxes minus transfers) by NT. Also, denote the net disposable income by YD. As such, the relationship between the national income or output (Y) can be expressed as:

$$ YD= Y-NT=(1 – t)Y $$

Where:

\(t\) = Net tax rate.

Note that net taxes are often assumed to be proportional to national income, meaning that the total tax revenue from net taxes is \(tY\). If we assume that t is 30%(0.3), every $1 rise in national income will increase the net revenue by $0.3 and the disposable income of each household by $0.7.

Note that those who benefit from increased government spending will usually save a proportion\((1 – c)\) of each extra dollar of disposable income, where ‘c’ represents the marginal propensity to consume (MPC) the additional income.

If we ignore taxes, it is easy to see that $c will be utilized by the recipients to buy more goods and services. Note that these recipients will also spend a proportion of c of the additional “c” income i.e \(c^2 (=c\times c=c^2)\). This process persists with both income and expenditure increasing at a steady rate of ‘c’ as it circulates from one entity to another throughout the economy, forming the sum of infinite geometric series given by:

$$ \frac{1}{1-c},\ 0 \lt c \lt 1 $$

The above expression implies that for every additional spending, total income and spending rise by \(\frac{1}{1-c}\) (ignoring taxes) since \(0<c<1\), \(\frac{1}{1-c}\) must be greater than 1, and that is the multiplier. If c is 80%, i.e., households spend 80% of the additional income, the multiplier = \(\frac{1}{1-0.8}=5\).

We can define the multiplier as the ratio of the change in equilibrium output to the change in autonomous spending that caused the change.

Before moving on, we must introduce marginal propensity to save (MPS), denoted by s. It is the amount saved out of an additional dollar of disposable income. As such,

$$ c+s=1 $$

So that,

$$ s=1-c $$

Recall that fiscal policies include government spending (G), net taxes (NT), and tax rates, t.

Households allocate a portion ‘c’ of their disposable income, YD, which means they spend:

$$ cYD= c\left(Y – NT\right)= c(1 – t)Y $$

Where:

\(Y\) = Total income or output.

\(NT\) = Net taxes (taxes minus transfers).

\(t\) = Net tax rate.

Note that the marginal propensity to consume in the presence of taxes is then \(c(1 – t)\). As such, when the government elevates its expenditure by a certain amount, G, the disposable income rises by \((1 – t)G\), meaning consumer spending will increase by  \(c(1 – t)G\).

Assuming there are unused sources of capital and labor in the economy, the recipients of the additional consumption spending will have \((1 – t)c(1 – t)G\) additional disposable income and will spend c of it.

This cumulative additional expenditure and income will persist in propagating throughout the economy at a diminishing rate, as \(0 \lt c(1 – t) \lt 1\), forming a decreasing geometric series with a common ratio of \(c(1-t)\) which sum to
\(\frac{1}{1-c(1-t)}\)

The above expression is called a fiscal multiplier:

$$ \text{Fiscal Multiplier}=\frac{1}{1-c(1-t)} $$

The fiscal multiplier holds significant importance in macroeconomics as it informs us about the magnitude of change in output resulting from exogenous alterations in government spending or taxation. In other words, variations in government spending (G) or tax rates will impact the output of an economy via the value of the multiplier.

Example: Calculating and Interpreting Fiscal Multiplier

Assume that in an economy, the tax rate is 25%, and the marginal propensity to consume is 80%; then the fiscal multiplier will be calculated as:

$$ \frac{1}{1-c(1-t)}=\frac{1}{\left[1 – 0.8\left(1 – 0.25\right)\right]}=\frac{1}{0.40} = 2.5 $$

This implies that if the government increases spending (G) by USD 1 billion, the overall incomes and expenditures will rise by USD 2.5 billion.

Balanced Budget Deficit

Note that if a government increases government spending(G) by the same magnitude as it raises taxes, aggregate output will increase. This is due to the multiplier effect.

Since the marginal propensity to consume from disposable income is less than 1, a one-dollar decrease in YD causes only a $c drop in spending. Therefore, the total reduction in spending is smaller than the tax increase by a multiple of c. Maintaining a balanced budget results in increased output, subsequently causing more increases in both output and income due to the multiplier effect.

It may be intuitive to think that increasing government spending (G) while raising taxes by the same amount would keep the government’s budget deficit/surplus unchanged. However, the rise in output leads to additional tax revenue and further changes in the budgetary position.

It is possible that the government can modify the initial change in spending to precisely offset the total change in total revenues, at which the balance budget multiplier is 1.

Question

Which of the following statements is the most accurate regarding fiscal tools?

1. Direct taxes are useful for discouraging alcoholism.
2. Indirect taxes cannot be modified quickly; therefore, they are irrelevant fiscal.
   policy tools
3. Government capital spending decisions are slow to plan, implement, and execute; thus, they are of little use for the short-term stabilization of the economy.

Solution

The correct answer is C.

The implementation of capital spending is slower compared to the implementation of changes in indirect taxes.

A is incorrect. Indirect taxes have a greater effect on alcohol consumption as compared to direct taxes.

B is incorrect. Indirect taxes can be modified quickly. In fact, among all the tools, their implementation is the easiest and fastest.